Tax Consequences of Changing Beneficiaries on a Life Insurance Policy

Most of the time beneficiary designations don't affect the tax treatment of the policy.

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Life insurance policies fill a variety of needs. They provide valuable income to families suffering from a death. They offer the liquidity necessary to ensure businesses and properties stay in the family. They even act as a speculative investment for some. Tax law grants special treatment for life insurance to encourage people to set aside income and provide for their families at their death. There are limits to that special treatment, however. Who you designate as your beneficiary can indicate what you want the policy to do, which has significant tax consequences.

Ownership Issues

When you own a policy against your own life, you have wide latitude in designating a beneficiary. The tax code typically excludes life insurance payouts from the beneficiary’s income, allowing the beneficiary to get the benefit tax-free. So long as you’re designating that person gratuitously that exclusion applies. When someone else owns a policy insured against your life that lists a third person as the beneficiary the proceeds might lose tax-free status.

Selling Your Policy

Someone who buys a life insurance policy in the hope of making a profit from the proceeds doesn’t get his investment subsidized by other taxpayers. He must pay tax on any gains above what he paid for the policy. Selling your policy typically involves assigning ownership over to the buyer, who then changes the beneficiary to himself. But you might also agree with someone to let him choose your beneficiary in exchange for something. The Internal Revenue Service might apply extra scrutiny to the proceeds if the beneficiary doesn’t have a clear connection to you.

Designating a Charity

You might want to use your life insurance to provide support for a charity. Naming a charity as your beneficiary provides a tax write-off. How and when you can make the deduction depends on what rights you keep. If you hand it over to the charity and designate the charity as a beneficiary you can write off the premiums as you pay them. But if you keep ownership of the policy then you could change your mind before you die. Your estate can take the death benefit as a deduction when it pays out to the charity at your death.

Naming a Trust

Trusts can allow you to set terms on how the proceeds of your life insurance policy are used after you die. The trustee must manage and distribute any income and assets according to the terms you establish. Under most circumstances naming a trust as your beneficiary won’t change the tax treatment of the proceeds. The face value of your life insurance policy will pay out tax-free to the trust and the trust can distribute the proceeds tax-free to its beneficiaries. If the designation of the trust appears part of a reciprocal agreement then the transfer for value rules might apply.

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About the Author

Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.

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