Will my life insurance beneficiary have to pay income tax on my death benefits?
Answers | 3
The general answer is NO.
Are there exceptions to this rule? Yes. But having a MEC (or Modified Endowment Contract) is NOT one of them. Both of the Agents that answered this question stating that having a MEC triggers income taxes on your death benefit for the beneficiary are incorrect.
TAMRA (or the Technical and Miscellaneous Revenue Act of 1988) changed the FIFO (first in, first out) tax treatment on distributions from a MEC during the life of the insured. A MEC is an overfunded life insurance policy (in violation of the 7-pay test as defined under TAMRA.) The income taxation of the death benefit from a MEC is the same as the income taxation of the death benefit from a life insurance contract (at the death of the insured) because a MEC is still considered a life insurance contract. In other words, the death benefit on a MEC is still income tax-free to the beneficiary.
Generally speaking, if the life insurance contract is structured properly there will be no income taxes owed by the beneficiary. What is the general rule on properly structuring your life insurance contract? You can ONLY have two parties to the insurance contract. The “insured” is one. The “beneficiary” is another. So the “owner” of the policy MUST be either the insured or the beneficiary. If the owner listed on the policy is anyone or any entity other than the owner or the insured, the death benefit is income taxable to the beneficiary. What are the common ways people mess this basic rule up? Dad is the insured, the company is the owner (and pays the premiums) and mom is the beneficiary. Mom will pay income taxes on the death benefit. How do you fix this? Transfer ownership from the company to the insured. This will correct the problem and avoid any “transfer for value” problems.
What is transfer for value? If at any time prior to the death of the insured the policy ownership was incorrectly structured and/or transferred or sold, there might be a violation of the “transfer for value” rules which could also trigger income tax consequences. These rules are VERY complex and beyond the scope of what you are asking. But keeping it simple, transferring ownership back to the insured will resolve and/or avoid these problems.
I hope this helps. I would be happy to answer any follow up questions you may have regarding the taxation of life insurance death benefits.