I Thought My Insurance Agent Told Me That Insurance Proceeds are Tax-Free. Did I Miss Something?

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Are My Insurance Proceeds Tax Free?

Life insurance is NOT always tax-free. One of the most common misconceptions about life insurance has to do with its tax status. In virtually all circumstances, life insurance proceeds are income tax free. The premiums were paid with after-tax dollars and the death benefit is not subject to income tax.

However, life insurance is not necessarily estate tax free. Any assets owned in your estate are potentially subject to estate tax. Most life insurance policies are owned by the insured and therefore included in the estate of the insured. One of the biggest errors by clients in estimating the size of their estate is failing to include the death benefit of life insurance they own.

One of the easiest ways to reduce the size of your estate is to have an irrevocable life insurance trust (ILIT) own the policy rather than yourself. Existing policies can be gifted to that trust, or new life insurance can be acquired by the trust. Life insurance that is gifted to an irrevocable trust is subject to being included in your estate for three years after the date of the gift. Insurance that is initially acquired by the trust can be immediately excluded from your taxable estate.