Life Insurance Benefits: Taxable Or Not?

Life insurance payouts are generally not taxable, but there are some exceptions. Typically, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income and is not subject to income or estate taxes. However, if the payout is structured as multiple payments over time, these payments may be taxable. This is because they can include proceeds and interest, and interest is generally taxable. If the policyholder names their estate as the beneficiary, taxes may also apply, depending on the estate's value. Additionally, if the insured and the policy owner are different individuals, there may be taxes involved.

Interest on life insurance proceeds

Life insurance proceeds are generally not taxable as income. However, there are some exceptions to this rule. One such exception is when the proceeds have accumulated interest. In this case, the beneficiary must pay taxes on the interest, though not on the entire benefit. For example, if a death benefit of $500,000 earns 10% interest over one year before being paid out, the beneficiary will owe taxes on the $50,000 growth.

If the beneficiary of a life insurance policy receives the payout in instalments, the insurance company will typically pay interest on the outstanding death benefit. This is often the case when the beneficiary is a young child or someone dependent on the income of the deceased. In these cases, the beneficiary must pay income tax on the interest.

If the policyholder names their estate as the beneficiary of their life insurance policy, the person or people who inherit the estate may have to pay estate taxes. This is because the life insurance payout will be added to the value of the estate. If the total value exceeds the federal and state exemptions, any amount over the exemption will be subject to estate and inheritance taxes.

To avoid paying taxes on the interest accrued by a life insurance policy, the policy owner can transfer ownership of the policy to another person or entity. They can also set up an irrevocable life insurance trust (ILIT), which will own the policy instead of the owner. This means that the proceeds will not be included in the owner's estate, and the owner can determine how the beneficiaries will receive or use the payout.

Naming the estate as beneficiary

Naming the estate as the beneficiary of a life insurance policy is a common mistake. This can happen intentionally or by default if the beneficiaries listed predecease the policyholder. In Florida, naming your estate as a beneficiary subjects these benefits to unwanted consequences.

By listing the estate as the beneficiary of the life insurance policy, the proceeds become an asset of the probate estate and are subject to the claims of creditors. Probate will be required to collect and distribute the assets, which can take months. Life insurance proceeds that are paid to the estate are then subject to all of the costs associated with settling an estate, including taxes, administrative costs, attorney fees, and executor fees.

In many states, life insurance proceeds are exempt from the claims of creditors when there is a named beneficiary, but not when the estate is the named beneficiary. This means that by leaving the benefits of your life insurance policy to your estate, you open up the opportunity for creditors to collect from those proceeds to satisfy their claims. That means your life insurance proceeds could be used to pay off any outstanding debts you may have at the time of your death before distribution to the beneficiaries of your estate.

A better plan may be to name a trust as the beneficiary. Proceeds distributed to a carefully constructed trust will be shielded from the claims of creditors. Additionally, it prevents the life insurance proceeds from being included in the probate estate. Naming the trust as the beneficiary eliminates additional steps and time involved in collecting the proceeds that would be involved if the estate was the beneficiary. Also, with the trust as the beneficiary, the distribution of the proceeds will not be postponed due to satisfying debts, expenses, or creditors' claims of the estate.

Policy owner and insured are different

When the owner of a life insurance policy is not the same as the insured, the payout to the beneficiary could be considered a taxable gift. This is because the IRS treats the death benefit as a gift from the policy owner to the beneficiary.

To avoid this, you can transfer ownership of the policy to the beneficiary or another person or entity. This is known as an ownership transfer. However, note that if you transfer the policy within three years of your death, the IRS will treat it as if it still belongs to you. You will also need to be aware of gift tax limits. In 2024, the annual gift tax exemption is $18,000, and the lifetime exclusion amount is $13.61 million.

Another way to avoid taxation is to create an irrevocable life insurance trust (ILIT). This allows you to transfer ownership of the policy from yourself to an ILIT and, therefore, remove it from your estate. However, be aware that this kind of trust cannot be revoked after you set it up.

Payout structure

Life insurance payouts are generally not taxable. However, there are some exceptions to this rule.

Lump-sum payments are typically not taxed. However, if the beneficiary elects to receive the payout in multiple payments, the interest accrued on the account may be taxable. This is because the payout is considered to be a part of the beneficiary's gross income. The beneficiary will have to pay income taxes on the interest accrued.

For example, if the death benefit is $500,000, but it earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth.

In the case of an annuity, which is paid out regularly over the life of the beneficiary, the payments can be subject to taxes as they include proceeds and interest.

Employer-paid group life plan

If you're enrolled in an employer-paid group life plan, it's important to understand the tax implications. Here's a detailed overview:

Tax-Free Coverage up to $50,000

According to the Internal Revenue Service (IRS) Code Section 79, the first $50,000 of group term life insurance coverage provided by your employer is tax-free. This means you won't pay any taxes on this portion of your benefit. It's excluded from your taxable income and won't increase your income tax bill. This provision ensures that employees can access a significant amount of tax-free life insurance coverage through their employer-paid group plan.

Taxable Income for Coverage Exceeding $50,000

However, if the coverage provided by your employer exceeds $50,000, the additional amount becomes taxable. The cost of group term coverage above $50,000 is considered taxable income for the employee. This is often referred to as "phantom income" because you're taxed on income you never actually receive. The taxable amount is determined using an IRS Premium Table, which calculates the cost based on the employee's age. This taxable amount is then included in the employee's taxable wages reported on their Form W-2, and it's subject to federal, state, and local taxes, as well as Social Security and Medicare taxes.

Employer Cost Redistribution

Additionally, a taxable fringe benefit arises if the employer subsidizes the cost of coverage or redistributes it among employees. This means that even if employees are paying the full cost they are charged, the benefit is still taxable if the employer affects the premium cost through its redistributing role. In such cases, you must calculate the taxable portion of the premiums for coverage that exceeds $50,000.

Nondiscrimination Requirements

It's important to note that employers must meet certain nondiscrimination requirements when offering group-term life insurance. These requirements are designed to prevent discrimination in favor of highly compensated employees and ensure that lower-compensated employees are not excluded from participating due to the price of the benefits. To avoid discrimination, the plan should benefit at least 70% of all employees, with at least 85% of participating employees being non-key employees. Alternatively, the plan can benefit employees who qualify under a non-discriminatory classification set up by the employer and approved by the IRS.

Group Life Insurance Considerations

Group life insurance through your employer is a valuable benefit, but it's important to consider its limitations. The coverage is linked to your employment, so if you change jobs, stop working, or retire, the coverage will typically end. Additionally, the amount of coverage provided by your employer may not be sufficient to meet your loved ones' financial needs. Therefore, it's often recommended to supplement employer-provided group life insurance with an individual policy to ensure adequate coverage.

Frequently asked questions