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Tax treatment of life insurance proceeds varies

By HELEN HUNTLEY

© St. Petersburg Times, published August 15, 1999


Q. I am 54 and just beginning to plan for the inevitable. We own a small family business, and life insurance proceeds are meant to pay living expenses when one of us dies. I am confused about the tax treatment of life insurance proceeds. I read that they are not taxable, but then I heard they must be figured in the value of the estate for tax purposes. Do life insurance proceeds become taxable when the estate is bigger than $650,000?

A. Yes and no. You and your spouse do not have to worry about estate taxes if you are leaving your business, life insurance benefits or anything else to each other. But if you have other beneficiaries in mind, it's a different story. Particularly if you expect your business to go on after your deaths and you want your children to own it, taxes become a big issue. You need some good legal advice.

Some people create a family partnership or an S corporation and gradually give their children shares. Some buy life insurance so the children will be able to pay the estate taxes. One common way to handle this is to set up a trust to own the life insurance policy, which keeps the proceeds out of the estate.

Taxation of life insurance can be confusing because there are two different types of taxes at issue. Life insurance proceeds are not subject to income tax unless the policy was transferred for money as it is in a viatical settlement investment.

Most of the time life insurance proceeds are part of the estate for estate tax purposes. As you have noted, estate tax is only an issue if your estate is bigger than $650,000 (increasing to $1-million by 2006.) Anything left to a spouse who is a U.S. citizen is deducted from the estate before figuring the tax.

Q. My daughter is going to college in a few weeks and I am worried about running short of money before the year is over. Do you have any last-minute suggestions?

A. In addition to loans designed especially for parents or students, consider a home equity loan if you own your own home or a margin loan if you have a brokerage account. Just be sure that you don't borrow more than you can afford to repay.

Sallie Mae, the largest source of funding for student loans, operates telephone information hotlines from 8 a.m. to 11 p.m. weekdays. The numbers are (800) 891-4599 for students and (800) 891-1410 for parents. You also should contact the financial aid office at your daughter's college to ask about last-minute sources of help and job opportunities for part-time work for your daughter.

And, of course, you will want to be sure to get the financial aid application forms in early next year.

Q. Why are my annuity withdrawals taxed as ordinary income when corporations get a special tax break for capital gains? It appears to me that both are in the long-term bracket and both should be treated equally.

A. Both individuals and corporations get a tax break on the treatment of long-term capital gains. If you had bought stocks, bonds or mutual funds instead of annuities, then your dividends and interest would have been taxable income when you received them, but any gains would be taxed at the lower capital gains rate when you sold. If you never sold, the gains could escape taxation altogether because your heirs would received a "stepped-up basis" to the market value at your death.

With an annuity you got the benefit of tax deferral during the accumulation period, a valuable tax break of a different kind. Now that you are withdrawing the money, you have to pay ordinary income tax, but part of each distribution is considered tax-free return of principal, another tax break.

Although they are not the most important consideration, taxes should be part of investment decisionmaking. If you wanted capital gains tax treatment more than you wanted tax deferral, an annuity probably was not the right investment for you.

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-- Helen Huntley writes about investing and markets for the Times. If you have a question about investments or personal finance, send it to On Money. We'll try to answer those we think are of greatest reader interest. All questions must be submitted in writing, but readers' names will not be published. Send questions to Helen Huntley, Times, P.O. Box 1121, St. Petersburg, FL 33731, or to huntley@sptimes.com by electronic mail.

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