There are several ways to set up a life insurance policy to prevent it from causing financial problems for your beneficiaries. Most life insurance policies automatically prevent the proceeds from being considered income tax, for example, but you can make the money completely tax free if you use a little planning.
The easiest way to make sure that the proceeds of your life insurance policy go where they are meant to go is to set up the policy with a trust as the beneficiary. You can use more than one trust for each policy, and the trust can be set up to either pay out a lump sum, or to dole out the proceeds over a course of years, such as being used to pay the household utilities on a regular basis.
The situation that leaves your life insurance proceeds subject to heavy taxation is if you choose your estate as a beneficiary, or if you do not name any specific beneficiary. In this event, the life insurance policy pays out directly to your estate, and that means the money will be taxed during the final estate taxes, usually engulfing 40 percent of the proceeds, or more. For this reason, it is never a good idea to assign your estate as a beneficiary in a policy.
If your beneficiary owes back taxes, the proceeds from your policy can be garnished to pay the past taxes. The only way to prevent the IRS from taking their share out of a life insurance policy is to set the policy up to pay to a trust instead of paying directly to the beneficiary. As long as the money is managed before it gets to the beneficiary, you can make sure that your loved ones, not the federal government, get the majority of what you leave behind.