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I had always thought that life insurance proceeds were not treated as taxable income. From IRS publication 525:

Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract. However, interest income received as a result of life insurance proceeds may be taxable.

However, when I Google "life insurance proceeds estate tax", lots of scary-looking legal advice comes up, suggesting complex estate tax planning. It's not clear to me whether this is a valid concern.

I'm not looking for a treatise on the estate tax; I just want to know: if my wife and I were to pass away, would our children have to pay taxes on our life insurance proceeds, or not?

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Edit: Adding a bounty as we have two contradictory answers with the same number of upvotes.

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    I forgot to add: no need to apologize for the morose topic. We're all (hopefully) adults here. :)
    – George Marian
    Sep 3, 2010 at 18:27
  • I defer to @JoeTaxpayer and have changed my answer to an external source supporting JoeTaxpayer. I recommend he get the bounty over me, but it's your call.
    – Alex B
    Oct 6, 2010 at 18:25
  • @Alex B - I am honored by your complement and support. Thank you.
    – JTP - Apologise to Monica ♦
    Oct 9, 2010 at 1:03

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There seems to be a bit of confusion here. Let me answer as if the 2011 estate tax exemption amount is back to $1M. It's just you and the kid. Your total worth when you pass on is $500K plus you own that $1M policy with your son as beneficiary. The estate is valued at $1.5M and tax is due on $500K. What matters is who owned the policy, not who the beneficiary is.

As the kids get older, you are best off transferring ownership (even if the policies are term) and gifting them money to pay the premium. This avoids the convoluted plans you may have read about.

Your question helps exemplify why the changing estate tax laws are so difficult. 2009 the exemption was so high, my wife and I had nothing to worry about. Next year, it's easy to go over.

The very simple answer is "yes, if you own the policy, it's part of your estate for tax purposes."

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For those estates that do owe taxes, whether or not life insurance proceeds are included in the taxable estate depends on who owns the policy when the insured person dies. If the deceased person owned the policy, the full amount of the proceeds are included in the federal taxable estate; if someone else owned the policy, the proceeds are not included.

Source

Kudos to JoeTaxpayer for his comments leading to a better answer.

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    Follow-up question: what's the difference between my children and my estate? If my children are named beneficiaries, then none of my life insurance will be paid to the estate, correct?
    – Portman
    Sep 5, 2010 at 5:56
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    @Portman: You are correct. If your children are named beneficiaries, they the life insurance is separate from your estate. You can think of your estate as everything you own. It is passed to your heirs through probate (legal term meaning roughly "doing what a will says"). After death, your estate is responsible for paying your last round of taxes, taking care of any creditors, etc. etc. It only has the funds left in the estate available to it.
    – Alex B
    Sep 5, 2010 at 8:51
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    Alex - if Portman is the policy owner, it's part of his estate, part of the estate tax limits. The children won't owe taxes, per se, but the proceeds may first be subject to the tax before they get their share.
    – JTP - Apologise to Monica ♦
    Sep 22, 2010 at 22:52
  • I changed my answer. My original answer was specific to income tax and did not discuss estate tax.
    – Alex B
    Oct 6, 2010 at 18:26
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According to the IRS publication, payments of the contracted payable amount made to the individual who is the beneficiary are not taxed. Interest above the payable amount is taxed as interest.

However, life insurance paid to the estate is taxable by estate taxes, so make sure your beneficiaries are the correct people. Some people look at the $2 million estate tax exclusions and assume they aren't worth that much money, but insurance payments on top of a home and other assets can add up.

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    Follow-up question: what's the difference between my children and my estate? If my children are named beneficiaries, then none of my life insurance will be paid to the estate, correct?
    – Portman
    Sep 5, 2010 at 5:55
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Simple answer:

Life insurance proceeds are income tax free in most cases, but not always estate tax free.

If the life insurance policy are included in your estate and your estate is over the exemption limit for the year that you expire, then taxes will be taken out of your estate.

If your estate is not over the exemption limit, no need don't worry. You can sleep well at night.

When is it taxable?

If the life insurance policy is paid with pre-tax money (this is done through a qualified retirement plan), then a portion of proceeds are taxable. Mind you, these instances are very rare.

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