Life insurance proceeds such as death benefit are guaranteed lump sums of money paid to beneficiaries and are typically tax-free. However, there are some circumstances when they’re subject to tax, such as when the beneficiaries are declared as revocable.
Life insurance is one of the foundations of a stable financial plan. It is important as it provides a family a financial safety net. It provides money to beneficiaries to pay for things like mortgage, college and more, should anything happen to the insured. But unlike most large sums of money, e.x.lottery winnings, life insurance proceeds are usually not taxable.
Life insurance and the tax code
When a person dies, all of his assets properties and investments become part of his estate and hence, subject to estate tax. Estate tax is not a property tax but a tax on right of the deceased person to transfer his estate to his heirs and beneficiaries.
Under the new TRAIN law, Revenue Regulations No. 12-2018, the estate tax is established at the fixed rate of six percent (6%) from previously graduated tax rate from 5% to 20%. The gross estate is also allowed with P 5,000,000 standard deduction, Php10,000,000 family home and valid deduction from claims against the estate. Passing of this TRAIN law simplifies the estate taxation.
But, regardless of the tax reform, do life insurance proceeds form part of the deceased person’s estate? Under Section 85(E) of the National Internal Revenue Code, proceeds from life insurance shall be included in the computation of the gross estate of the deceased when the beneficiary is the estate, executor or administrator, whether the designation is revocable or irrevocable, and when the beneficiary is other than the estate, executor or administrator and the designation is revocable. Hence, it all depends on the beneficiary of the insurance policy.
Revocable vs Irrevocable Beneficiaries
Life insurance policies may have a revocable or irrevocable designation of the beneficiaries. A beneficiary of a life insurance policy is the person who will receive the money upon the death of the insured.
A revocable beneficiary in a life insurance policy can be changed by the owner of the policy without the signature of the beneficiary. Meanwhile, an irrevocable beneficiary requires the beneficiary to sign off on any policy changes. Therefore, should the policy owner wish to change the beneficiary on a policy where an irrevocable beneficiary exists, both the policy owner and the irrevocable beneficiary must sign off on it.
Designating the beneficiary as irrevocable makes the policy owner lose the flexibility in making any changes, withdrawals or even changing beneficiaries. However, the major advantage of it is the death claims will not be subject to tax.
How about critical illness benefits, are they taxable?
Critical Illness benefit may be a stand-alone type of life insurance or rider to the basic plan in case of a Variable Life Insurance (VUL). This protection guarantees to pay out a lump sump if insured is diagnosed with a life-threatening illness such as cancer or heart disease.
Because this benefit is similar to a life insurance plan in a way that they both offer protection, rather than income or profit, the money provided by critical illness insurance is not taxable.