Yellowstone Financial, Inc.

Tax pitfalls with surprising penalties

Death and taxes. Both are unavoidable, but at least one of them can be minimized while alive and by your heirs once you’re gone.

Q: My mother-in-law currently has a CD that has come due. Is it true that upon death her CD would be taxed to the beneficiaries as regular income?

A: Interest on CDs is taxed as ordinary income, which can be up to 35 percent at the federal level and close to 5 percent for Colorado. Unfortunately her heirs cannot escape these taxes in death. In her year of death, the interest she had the right to receive would appear on her tax return. The personal representative of the estate files a final 1040 with the income from the last months of her life.

If the estate continued to hold the CD after her death, then the interest would be taxable to the estate or the beneficiaries of the estate. The personal representative of her estate would file a tax return if there is income of $600 or more.

There is a morbid but potentially profitable method of purchasing long-term negotiable CDs for those who are relatively close to their life expectancy. Negotiable CDs fluctuate in value like bonds and can be purchased through your online or retail broker. If the CD has a “death put” option, that gives heirs the choice to turn in the CD for its original value or retain it. If interest rates have gone up instead of being locked into a low yielding CD, you can trade it out for a better rate.

Q: If she deposits money in an insurance investment, would there be no taxes on it upon her death?

A: It’s true that life insurance has powerful tax benefits for beneficiaries. Life insurance death benefits are generally not subject to income tax. If a 40-year-old father with a family of four dies with a $1 million term life insurance policy in force, the beneficiaries of the policy would be due $1 million free of income taxes. It would be potentially subject to estate taxes, but with the current estate tax exclusion at just over $5 million, this wouldn’t be much of an issue for most.

For your mother-in-law, if she purchased a life insurance policy then the death benefit would not be subject to income tax. This is in contrast to an annuity held outside of an IRA, which can be a tax bomb for beneficiaries. With annuities, the income accrued above basis is taxable. While there are methods to delay paying income taxes on inherited annuities, the taxes cannot be avoided.

Q: Is insurance a safe investment and is it guaranteed by the National Organization of Life and Health Insurance Guaranty Association?

A: The first level of protection is the sound credit of the insurance company that issues the policy. By going to weiss.com you can access the financial strength ratings of a number of insurers. Your insurance agent can also provide ratings by Weiss, A.M. Best, S&P and Moody’s.

You can get these quickly at immediateannuities.com under “Company Ratings.” Weiss tends to be less biased than the others and has a better track record of predicting trouble, although the other ratings agencies have more resources for in-depth analysis.

The organization you mention is made up of the all of the state guaranty associations, including the Colorado Life and Health Insurance Protection Association (colorado.lhiga.com). This association is made up of insurers that issue life and health policies in Colorado. The association provides up to $300,000 in coverage for death benefits and $100,000 for cash value in a life insurance policy to Colorado residents in case the insurance company becomes insolvent.