Life Insurance Payouts: Taxable Or Tax-Exempt?

Life insurance is often taken out to provide peace of mind that loved ones will have financial support in the event of the policyholder's death. While the proceeds from a life insurance policy are usually tax-free, there are some situations where beneficiaries may have to pay tax. This paragraph will explore when life insurance gains are taxable to the beneficiary.

Interest on life insurance payouts

Life insurance death benefits are typically tax-free, but there are a few exceptions. For example, if your loved ones choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. This is because the interest is considered taxable income, even though the original death benefit is not.

Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate's total value is large enough, it may trigger estate taxes, reducing what your loved ones ultimately receive.

If you choose to receive the death benefit in installments, the insurer typically holds the principal amount in an interest-bearing account and issues a percentage of the death benefit over a set number of years. While installments provide a steady income stream, the interest that accumulates on the death benefit is subject to income tax.

The younger you are when you receive a life insurance payout, the more appealing the lump sum option is. You need flexibility because your needs for that money could change over time. If you are older and in retirement when you receive an insurance payout, an annuity option can be more appealing. It provides a guaranteed source of income and takes away the risk of losing money if you were to invest it.

If you receive the payout in installments, the interest that accumulates on the death benefit is subject to income tax. The original life insurance death benefit typically isn't, though.

Life insurance and estate taxes

Life insurance payouts are usually tax-free, but there are some situations where taxes may apply. Here's what you need to know about life insurance and estate taxes:

Estate Taxes

If the life insurance policy is owned by the deceased and the payout is included in their estate, it may be subject to estate taxes. In the US, the federal estate tax exemption limit for an individual is $13.61 million in 2024. So, if the total taxable value of the estate, including the life insurance payout, exceeds this amount, the IRS will levy an estate tax.

To avoid this, you can ensure that the estate is not named as the beneficiary of the policy. Instead, name specific individuals as beneficiaries, who will then receive the life insurance payout tax-free.

Another way to avoid estate taxes is to transfer ownership of the life insurance policy to someone else or to an irrevocable life insurance trust (ILIT). This removes the policy from your taxable estate, but you must survive for at least three years after the transfer for this to be effective, due to the 'three-year rule'.

Taxation on Instalment Payouts

If the beneficiary chooses to receive the life insurance payout in instalments rather than a lump sum, any interest that accumulates on those payments will be taxed as regular income.

Taxation on Surrendering or Selling a Policy

If you surrender or cancel your life insurance policy, any amount you receive over and above the total premiums you have paid will be taxed as regular income.

Similarly, if you sell your life insurance policy, any amount you receive over and above the total premiums you have paid will be subject to income tax, and any profit you make will be subject to capital gains tax.

Taxation on Withdrawing More than the Policy Basis

With whole life insurance and other permanent life insurance policies, you can build up a cash value over time, which you can then withdraw. However, if you withdraw more than the total amount of premiums you have paid, the excess may be subject to income tax.

In summary, while life insurance payouts are generally tax-free, there are some situations where taxes may apply, particularly if the payout is included in the estate of the deceased, if it is paid in instalments, or if the policy is surrendered, sold, or has cash withdrawn. By understanding these potential tax implications, careful planning can be used to minimise or avoid these taxes.

The Goodman Triangle

To understand the Goodman Triangle, it is important to distinguish the three relevant parties to a life insurance contract:

• Owner: The policy owner has control over the policy, including naming beneficiaries, terminating or altering the policy, and ensuring premium payments are made.
• Insured: The person whose life is insured by the policy.
• Beneficiary: The beneficiary receives the death benefit when the insured passes away. A policy can have multiple beneficiaries.

In most cases, life insurance proceeds from a death benefit are not taxable. For example, if you own a policy on your spouse and are the beneficiary, you will not owe taxes on the amount received upon their death. However, a Goodman Triangle arises when there is a non-owner beneficiary. If you own a policy on your spouse and name your child as the beneficiary, the amount your child receives upon your spouse's death is taxable.

Since the child did not own the policy, the death benefit they receive is considered a gift under gift tax rules. It is important to understand when the gift occurs. The taxable gift occurs once the gift has been completed. Before the death of the insured, the policy owner can change or cancel the policy, thereby altering the amount of the gift. Therefore, the gift is only completed once the insured dies, as the owner can no longer change the terms of the policy.

There are several strategies to avoid the Goodman Triangle:

• Make the Beneficiary and the Owner the Same Person: By making yourself, as the owner, the beneficiary of the policy, it is no longer considered a taxable gift. However, the intended beneficiary will not receive the death benefit.
• Use an Irrevocable Life Insurance Trust (ILIT): An ILIT is created specifically to hold life insurance so that the death benefit avoids estate tax. The trust is named as both the owner and beneficiary of the policy, and a trustee handles the proceeds according to the trust document for the benefit of the trust beneficiaries.
• Ensure Two Points on the Triangle are the Same Person: Remember that the policy owner can also be the insured or the beneficiary, but the insured can never be the beneficiary. For spouses, this could mean that one spouse takes out a life insurance policy on themselves and names the other spouse as the beneficiary, or vice versa.

Surrendering a life insurance policy

Whole and universal policies

Whole and universal policies accrue cash value, making them the most likely option for surrender. Depending on the type and age of the policy, they may have accrued a significant amount of cash value or very little.

Surrender fees

If your policy isn't very old, you may incur surrender fees, which will reduce the amount of cash you receive. Surrender fees are usually high in the early years of the policy and then gradually decrease over time.

Tax implications

The gain on your policy, however much it may be, will be taxed as income. Death benefits are tax-exempt, but the cash you receive from surrendering is taxable. Consult your tax professional before making any decisions.

When to surrender

If you're wondering when to surrender your life insurance policy, it will depend on the type of policy you have. For example, you should only consider cashing out, i.e. surrendering, a whole life insurance policy after you have held it long enough to minimise the surrender fees. In the first few years of holding a whole life policy, you may not be able to cash it out at all. After 10 or more years, the surrender fees often go down to 1% or may not be charged at all.

Alternatives to surrendering

Selling your life insurance policy is another way to maximise your return on the policy. This can result in a return that's 4 to 11 times higher than the cash surrender value.

Life insurance dividends

Dividends are distributed by insurance companies that invest the premium payments they receive. If the company keeps expenses down and its investments perform well, they will declare a dividend, which returns a portion of the surplus to policyholders. Dividends are not guaranteed, and the calculation method is not disclosed.

Whole life insurance policies can be eligible for dividends if they are "participating" policies. A participating policy charges a higher premium and, in return, pays regular dividends to the policyholder. "Non-participating" policies do not pay dividends and usually have lower premiums.

If you have a participating policy, you can typically choose from several dividend options, including receiving a cash payment, using the dividend to reduce future premium payments, or leaving the dividend with the insurance company to collect interest.

It's important to note that life insurance proceeds are generally not taxable for beneficiaries. However, any interest earned on the proceeds is taxable and should be reported. Additionally, if the policy is transferred to the beneficiary for cash or other valuable consideration, the exclusion for the proceeds may be limited.

Frequently asked questions