Life Insurance Proceeds: Are They Taxed In New Mexico?

Life insurance is often seen as a reliable way to provide for loved ones after your death. One of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs or securing their future. However, there are some situations where taxes could come into play, and it's important to know when that might happen.

Life insurance proceeds are not taxed as income

However, it is important to note that any interest accrued on the life insurance proceeds is taxable. If the beneficiary receives the payout in installments, the insurance company will hold the principal amount in an interest-bearing account. The interest generated during this period is subject to income tax.

Additionally, if the policy was transferred to the beneficiary for cash or other valuable consideration, the exclusion for the proceeds may be limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. In such cases, the beneficiary would need to report the taxable amount based on the type of income document received, such as a Form 1099-INT or Form 1099-R.

While life insurance proceeds are typically not taxed as income, there may be other tax implications, such as estate or gift taxes, depending on the specific circumstances and the value of the estate.

Interest accrued on proceeds is taxable

In the state of New Mexico, life insurance proceeds are generally not taxable. However, any interest accrued on the proceeds is taxable and must be reported as such. This means that if you, as the beneficiary, receive life insurance proceeds after a period of interest accumulation rather than immediately upon the policyholder's death, you must pay taxes on the interest. For example, if the death benefit is $500,000 but earns 10% interest for one year before being paid out, you will owe taxes on the $50,000 growth.

The IRS considers life insurance proceeds you receive as a beneficiary due to the death of the insured person as non-includable in gross income, and therefore, you do not need to report them. However, if the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds may be limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts. There may be exceptions to this rule, and you should refer to the IRS guidelines for more information.

To avoid paying taxes on life insurance proceeds, you can consider transferring ownership of the policy to another person or entity. This way, the proceeds will not be included in your taxable estate. However, it is important to note that the original owner must forfeit any legal rights to the policy and should not pay the premiums to maintain the tax advantage of the transfer. Additionally, ensure that proper documentation and reporting requirements are met in a timely manner to minimize associated taxes related to interest earned during the collection process.

Naming the estate as beneficiary may trigger taxes

Naming your estate as the beneficiary of your IRA or retirement plan is usually the worst possible choice in terms of tax implications. Here are some reasons why:

Higher Taxes

The estate is required to distribute the funds under a five-year rule, whereas most individuals will have a 10-year window. The shorter timeline results in higher annual withdrawals, leading to higher potential taxes.

Higher Medicare Charges

The higher annual payments can also lead to higher Medicare charges.

Social Security Payments Subject to More Tax

The larger annual payments can also make your Social Security payments subject to more tax.

Probate Fees

Funds left to a named beneficiary are generally protected from creditors. However, assets in your estate are not, and they may be exposed to probate fees, legal fees, and other estate administration costs.

Gift Tax

If the insured, policy owner, and beneficiary are three separate individuals, gift tax may be triggered.

Estate Tax

While life insurance proceeds are generally not subject to estate tax, leaving money to your estate increases its value, which could subject your heirs to exceptionally high estate taxes.

Loss of Control

When you name your estate as the beneficiary, you lose the contractual advantage of naming a person. This means the financial product will be subject to the probate process, and you will sacrifice some planning options.

The insured and policy owner being different individuals may cause taxation

In most cases, the insured and the policy owner are the same person. However, there are instances where the insured and the policy owner are different individuals. This can occur when a business purchases key person insurance on a crucial employee, such as a CEO, or when an insured sells their policy to a third party for cash in a life settlement. In these situations, the IRS may conclude that the death benefit amount from the policy owner to the beneficiary is a gift, and gift tax may be incurred.

The gift tax is typically due upon the death of the insured, but if the gift exceeds the annual exemption amount, the beneficiary may have to pay the gift tax on the amount above the exemption. For example, if the annual exemption is $17,000, and the death benefit is $20,000, the beneficiary would owe gift tax on the difference of $3,000. It's important to note that the gift tax exemption and threshold limits may vary from year to year and are subject to change.

To avoid gift tax on life insurance proceeds, individuals can consider transferring ownership of the policy to another person or entity. This strategy, known as an ownership transfer, requires choosing a competent adult or entity as the new owner, who will then be responsible for paying the policy premiums. It's important to obtain written confirmation from the insurance company as proof of the ownership change.

Another option to avoid gift tax on life insurance proceeds is to create an irrevocable life insurance trust (ILIT). In this case, the policy is held in trust, and the original owner gives up all rights to make changes to the policy. The proceeds are then distributed to the beneficiaries according to the terms of the trust.

It's worth noting that the IRS has developed rules, such as the three-year rule, to determine the ownership of a life insurance policy when the insured person dies. Additionally, the IRS will look for any incidents of ownership by the person who transfers the policy, such as the right to change beneficiaries or borrow against the policy. These factors can impact the tax implications of the life insurance proceeds.

In summary, when the insured and policy owner are different individuals, gift tax may be incurred on the death benefit. However, this can be mitigated by carefully considering ownership transfer or establishing an irrevocable life insurance trust. It's important to seek professional advice to understand the specific rules and regulations that apply to your situation.

Use an ownership transfer to avoid taxation

While life insurance proceeds are not usually taxable, there are situations where the beneficiary may have to pay taxes on some or all of a policy's proceeds. For example, if the policyholder delays the benefit payout and the money is held by the insurance company for a certain period, the beneficiary may be taxed on the interest generated.

To avoid paying any taxes on life insurance proceeds, you can use an ownership transfer strategy. Here are the key steps and considerations for using an ownership transfer to avoid taxation:

• Choose a competent new owner: Select a competent adult or entity to be the new owner of the policy. This can be the policy beneficiary or someone else.
• Obtain the necessary forms: Contact your insurance company to request the proper assignment or transfer of ownership forms.
• Understand the rights and responsibilities: The new owner will be responsible for paying the policy premiums. As the previous owner, you will give up all rights to make changes to the policy in the future, including updating coverage or designating beneficiaries.
• Be aware of the irrevocability: Keep in mind that the ownership transfer is an irrevocable event. This means you cannot cancel or reverse the transfer once it is completed.
• Divorce considerations: When planning the ownership transfer, be cautious in situations involving divorce.
• Obtain written confirmation: Ensure you receive written confirmation from your insurance company as proof of the ownership change.
• Understand gift tax implications: If the insured, policy owner, and beneficiary are three different individuals, gift tax implications may arise. Consult with a tax professional to understand the potential tax consequences.
• Three-year rule: It's important to note that if you die within three years of transferring ownership, the full amount of the proceeds will be included in your estate as if you still owned the policy. This is known as the three-year rule.
• Consider using a life insurance trust: An alternative to transferring ownership to another person is to set up an irrevocable life insurance trust (ILIT). This allows you to maintain some legal control over the policy while still removing it from your taxable estate.

By following these steps and considerations, you can effectively use an ownership transfer to avoid taxation on life insurance proceeds.

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