Life Insurance Maturity: Taxable In The Us?

Life insurance is often seen as a reliable way to provide for loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs, or securing their future. However, there are a few situations where taxes could come into play, and it's important to be aware of these 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 as regular income. Similarly, if a policy involves three different people – the insured, the policy owner, and the beneficiary – the death benefit may be subject to gift tax if it exceeds certain exemption limits. Additionally, cash value life insurance policies, like whole or universal life, have their own tax rules, and withdrawals above a certain amount may be considered taxable income. While life insurance proceeds are generally not taxable, careful planning is necessary to navigate these potential tax implications and ensure your beneficiaries receive the intended benefits without unexpected complications.

Foreign life insurance policies

There are several tax issues to consider when a US person owns a foreign insurance policy. Some policies generate dividends, capital gains, interest, and proceeds, all of which may be taxable. If the policy has a surrender or cash value, there may be additional tax issues, such as Passive Foreign Investment Company (PFIC) rules. FBAR and Form 8938 reporting may also be required.

PFICs are subject to complex and punitive tax rules, which aim to discourage US taxpayers from making passive investments abroad. US expats should be aware of and avoid PFICs if possible. A foreign life insurance policy may be considered a PFIC if it meets either of the following criteria:

• At least 75% of the corporation's gross income is passive income
• At least 50% of the corporation's assets are passive assets

If a foreign life insurance policy is considered a PFIC, the policyholder must report all the mutual funds held in the investment on Form 8621. Additionally, any time the insurance company buys or sells funds, it triggers a taxable event under excess distribution rules.

When it comes to reporting requirements, foreign life insurance policies are reported on both the FBAR and Form 8938. The maximum cash surrender value during the year must be reported. These reporting requirements apply to the policyholder, not the beneficiary.

US taxpayers should be cautious when considering foreign life insurance policies due to the potential tax and reporting consequences. US-based policies may offer similar benefits without the same reporting and taxation issues.

Cash value life insurance

There are several types of life insurance policies that may have a cash value portion, including whole, universal, variable, and indexed life insurance. Whole life insurance is a popular choice, offering lifelong coverage with fixed premiums, potential tax savings on the growth of the cash value, and a guaranteed death benefit as long as premiums are paid. Universal life insurance allows more flexibility, as the value of premium payments can be adjusted, and the death benefit can be scaled up or down. Variable life insurance provides greater access to investment tools, but it also involves more risk as the cash value depends on the performance of the chosen investments. Indexed life insurance is closely tied to the stock market, with the growth of the cash value determined by the performance of the chosen index.

The cash value of a life insurance policy can be used in several ways. Policyholders can make partial withdrawals, borrow against the cash value, or withdraw all the cash value and surrender the policy. The cash value can also be used to pay premiums or the cost of insurance. It's important to note that accessing the cash value of a life insurance policy may have tax implications, and there may be fees or penalties involved.

Compared to term life insurance, cash value life insurance tends to have higher premiums. However, it offers the advantage of lifelong coverage and flexible access to funds. When deciding whether cash value life insurance is right for you, consider your financial situation, goals, and the level of risk and flexibility you are comfortable with.

Term life insurance

When it comes to taxation, term life insurance is generally straightforward because there is no cash value component. The main concern with taxation is the death benefit payout and certain specific situations, like selling the policy. However, most of these scenarios can be avoided with proper planning. Here are some key instances when term life insurance might be taxed:

• Interest on Installments: If the death benefit is paid out in installments rather than a lump sum, any interest that accumulates on those payments will be taxed as regular income.
• The Goodman Triangle: A tax issue can arise when three different individuals are involved in a life insurance policy: the policy owner, the insured, and the beneficiary. In this case, the IRS may view the death benefit as a gift from the policy owner to the beneficiary, triggering a gift tax if the amount exceeds the annual exclusion limit (which is $18,000 in 2024). This complication can be avoided by having only two parties involved in the policy.
• Selling the Policy: Selling a term life insurance policy may trigger income and capital gains taxes. If the policy is sold for more than the amount paid in premiums, the gain may be taxed. The portion of the sale amount that is equal to the cost basis (the amount paid in premiums) will not be taxed, but the portion that exceeds this amount will be subject to income tax, and any amount above the cash value will be subject to capital gains tax.
• Death Benefit and Estate Taxes: If the policyholder owns a term life insurance policy when they pass away, the death benefit becomes part of their taxable estate. This could push the estate's total value above the federal estate tax exemption ($13.61 million in 2024), triggering estate taxes.

By understanding the potential tax implications of term life insurance policies, policyholders can make informed decisions and engage in proper planning to minimise tax liabilities.

Permanent life insurance

The two primary types of permanent life insurance are whole life and universal life. The cash value of whole life insurance grows at a guaranteed rate, while universal life insurance offers more flexible premium options and its earnings are based on market interest rates. Other types include variable life and variable universal life, which provide expanded options to invest the cash value in mutual funds and other financial instruments.

Group term life insurance

One of the key advantages of group term life insurance is that participants are not required to undergo an underwriting process, making it a popular choice for those who may not be medically eligible for individual coverage. However, the amount of coverage offered by group life insurance may not be sufficient for all families, and it is important to note that this type of insurance only provides temporary coverage for the duration of employment.

When it comes to taxation, employers can provide up to $50,000 of tax-free group term life insurance coverage to their employees without any tax consequences. Any amount of coverage above $50,000 that is paid for by the employer must be recognized as a taxable benefit and included in the employee's W-2. Additionally, the premium for any additional coverage over $50,000 is taxed as ordinary income.

Frequently asked questions