Having enough life and disability> insurance should be a key element of your personal financial game plan. Hopefully, with some advance planning, you can collect life and disability insurance proceeds free of taxes. Here's how.
The main reason most people have life insurance is to replace income that would be lost if they die prematurely. Life insurance death benefit payments can generally be received by policy beneficiaries free of any federal income tax (and usually free of any state income tax too).
That's great, but what about the federal estate tax? If the tax rules treat you as the owner of a policy on your own life, the death benefit is included in your taxable estate -- unless the money goes to your surviving spouse, and he or she is a U.S. citizen. When death benefits go directly to a non-spouse policy beneficiary, such as a child or sibling (even without passing through your estate), the money is included in your taxable estate. If your estate exceeds $5 million (for 2011 or 2012), which it could if you have lots of life insurance coverage, your heirs will stand second in line behind the Internal Revenue Service (and possibly the state tax collector). Not good.
Here's the rub: The tax rules say you own a life insurance policy if you possess so-called "incidents of ownership." You have them if you retain the power to change policy beneficiaries, change coverage amounts, cancel the policy and so forth.
If having life insurance death benefits included in your taxable estate would cause an estate tax hit, the solution is to set up an irrevocable life insurance trust to own the policy. The trust then pays the premiums, and the death benefits go to whomever you name as the trust's beneficiaries. Your estate is out of the picture. With this arrangement, there's no federal estate tax on the death benefits, and there's no federal income tax either.
Naturally, there are a few complexities with this strategy. If you transfer an existing policy to the life insurance trust and die within three years, the death benefits are included in your taxable estate. To avoid this problem, the trust should purchase a new policy on your life. If that's not possible -- say because your health isn't so great -- you may have nothing to lose by transferring an existing policy and trying to outlive the three-year rule. But check with your estate planning pro first, because transferring existing policies with cash values in excess of $13,000 could trigger adverse gift tax consequences.
Finally, while setting up an irrevocable life insurance trust can be a great idea, it's not a do-it-yourself project because it's a fairly sophisticated legal procedure. Hire an experienced estate planning professional to get the job done right.
In addition to having adequate life insurance coverage, you should probably also have long-term disability (LTD) coverage to protect against lost earnings during any lengthy period out of work because of a disability. The catch? Most LTD policies limit benefits to only 60% or 70% of earnings before income taxes. That's generally OK as long as you don't have to pay income taxes. But if you do, you're probably going to lose 30% to 40% (or more) to the IRS and your state tax collector. That could cause your coverage to be insufficient (because 70% of 70% is only 49% of pre-tax earnings; 60% of 60% is only 36%; you get the idea).
Now for the good news: LTD benefits are generally income-tax-free when you, rather than your employer, pay the premiums. On the other hand, if your employer pays the premiums as a tax-free fringe, any LTD benefits will be fully taxable to you. The same is true if you set aside part of your salary to pay the premiums with before-tax dollars under your employer's cafeteria benefit plan. Here are two strategies to deal with this tax dilemma.
* If LTD benefits would be taxable because your employer is paying the premiums, the preferred solution is to arrange for the premiums to be paid with after-tax dollars by withholding from your salary checks. That way, the premiums are treated as part of your taxable salary, which will cause a slight increase in your income tax bill. However any LTD benefits will be tax-free, which is the bigger consideration here.
* The other alternative is to buy a supplemental LTD policy. The idea is to buy enough extra coverage to cover the income tax hit on the benefits that you would receive under the company-provided coverage. All benefits received under your personal LTD policy will be tax-free because you paid the premiums with your own after-tax dollars.