How Changing The Holder Of Your Life Insurance Plan Can Affect Its Tax Status
You take a life insurance policy so your loved ones or business partners enjoy a little more financial stability after you pass away, so it makes sense that many uses of the insurance payout are considered tax-free by the IRS. Unfortunately, there are many loopholes that make the tax status of the payouts unclear, even to the IRS itself due to a lack of coherent and clear internal rules. One of these problems arises when the policy switches owners. Watch out for making this kind of change to your insurance plan since the adjustments could interfere with the tax-free status of the policy.
The Usual Rules
In most cases, family members and other beneficiaries are not taxed on the money they receive as a payment from a life insurance policy. Even if the person holding the policy withdraws cash early instead of using the plan for its death benefits, the IRS allows this when the policy holder is facing a life threatening illness or other reason for exemption. However, this early payback plan becomes a lot more complicated to use once a policy is transferred to someone else.
Changing the Names
Problems start popping up when well-meaning life insurance users try to change names on their policies. For example, imagine Bob has a policy for $200,000. He is suffering from the early stages of dementia, so he decides to put his insurance policies in his wife's name so she can handle them as his cognitive abilities decline.
Even though his wife is most likely also his primary beneficiary, a problem arises if she wants to withdraw some of the benefits to use for Bob's care as he declines in heath. The IRS may or may not decide to collect capital gains taxes on the money she receives because she is also the technical owner of the policy, no matter how long it was in Bob's name before he transferred it to her. The relationship between the former and current owner of the policy doesn't matter to the IRS, and even the organization lacks any clear internal rules on how to handle these kinds of complicated situations.
Before signing over a policy to someone else for safekeeping, consider setting up a trust that includes the life insurance policy. An estate lawyer can work with your life insurance agent to create a contract that allows your loved ones to manage your policy, withdraw money as needed, and avoid unexpected capital gains taxes when you need the money the most for health care costs.