Life Insurance Payouts: Taxable Or Not?

Life insurance proceeds are generally not taxable, but there are exceptions. If you are the beneficiary of a life insurance policy, you will probably not owe any taxes on the death benefit. However, if the beneficiary is a third party, or if the benefit is paid out in installments, the beneficiary may be taxed on the interest generated. If the policyholder named an estate rather than an individual as the beneficiary, the person inheriting the estate may have to pay estate taxes.

Naming your estate as the beneficiary

When you name your estate as the beneficiary, you lose the contractual advantage of naming a real person and subject the financial product to the probate process. This means that instead of being immediately dispersed as per your will, your estate and assets will first go through probate court, where a judge determines what debts you owe. If you have any outstanding debts, creditors will be able to collect repayment from your estate. Only after these debts are settled will the rest of your estate be dispersed according to your wishes.

In contrast, when the life insurance death benefit is paid directly to your beneficiaries, it does not have to go through probate court. This means that creditors cannot collect your life insurance policy's death benefit if they are not listed on your policy, regardless of the debts you owe.

By listing your loved ones on your policy, you ensure that they are able to claim the death benefit directly. The easiest way to ensure your loved ones will receive the payout quickly and in full is to name the adult members of your family—like your spouse or adult children—as your primary beneficiaries.

If you want to connect your life insurance and your estate, you can set up a trust. Any assets included in a trust do not have to go through probate court, but it is best to work with an estate planning attorney and a financial advisor to ensure your belongings and the life insurance payout will be distributed according to your wishes.

It is important to keep your beneficiary designations up to date as your life changes (marriage, children, divorce, etc.).

Interest on proceeds

Life insurance proceeds are generally not taxable, but there are some situations in which the beneficiary may be taxed on some or all of a policy's proceeds.

Interest accrued on life insurance proceeds is taxable. If the beneficiary receives the payout 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.

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. The original life insurance death benefit is typically not taxed.

If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated during that period.

Estate taxes

Life insurance proceeds are generally not considered taxable income for the beneficiary. However, there are certain situations where taxes may be incurred, and careful planning is required to avoid these tax implications.

To avoid this, it is essential to ensure that your estate is not designated as the beneficiary of the policy. Instead, name a specific person or entity as the beneficiary to avoid the proceeds being included in your taxable estate.

Additionally, it is important to consider the three-year rule when planning your estate. According to this rule, if you transfer ownership of your life insurance policy within three years of your death, the proceeds will still be included in your estate and taxed accordingly. Therefore, it is advisable to plan ahead and make any necessary ownership transfers well in advance of this three-year window.

One way to remove life insurance proceeds from your taxable estate is to set up an irrevocable life insurance trust (ILIT). By transferring ownership of the policy to the trust and ensuring that you do not retain any ownership rights, the proceeds will not be included in your estate. This option allows you to maintain some legal control over the policy while also reducing potential tax liabilities.

Transferring ownership

Life insurance proceeds are generally not taxable, but there are some situations in which they can be. If you want to avoid federal taxation on your life insurance proceeds, transferring ownership of the policy to another person or entity is one way to do so. Here is some detailed information on transferring ownership:

Absolute Assignment

Absolute assignment involves transferring all rights and ownership of a life insurance policy from yourself to another person or a legal entity. This transfer is usually permanent and irrevocable. If you wish to proceed with an absolute assignment, you must notify your insurer, who will provide you with the necessary ownership forms. After an absolute assignment, you will no longer have any rights to make changes to the policy.

Collateral Assignment

A collateral assignment is a temporary transfer of ownership that allows you to use your life insurance policy as collateral to obtain a loan. If you die before repaying the loan, the bank will receive the funds from your policy and use them to pay off your debts. Any remaining proceeds will go to your designated beneficiaries. Once you repay the loan or meet other specific criteria, you will regain control of the policy.

Irrevocable Life Insurance Trust (ILIT)

An ILIT is a type of trust that owns a life insurance policy as its primary asset. This option allows you to maintain some legal control over the policy. You can also ensure that all premiums are paid promptly, which may be a concern if you transfer ownership to an individual. To complete an ownership transfer to an ILIT, you cannot be the trustee of the trust, and you must not retain any rights to revoke the trust.

Choosing a New Owner

When choosing a new owner, select a competent adult or entity (which can be the policy beneficiary). The new owner will be responsible for paying the premiums on the policy. You can gift a certain amount per person each year to help cover these costs.

Obtaining Confirmation

Make sure to obtain written confirmation from your life insurance company as proof of the ownership change.

Timing Considerations

Keep in mind that if you die within three years of transferring ownership, the proceeds will still be included in your estate and taxed accordingly. Additionally, if the policy's cash value exceeds the gift tax exclusion amount, gift taxes will be due at the time of the original policyholder's death.

Irrevocable life insurance trust

Life insurance proceeds are generally not taxable. However, any interest accrued is taxable and must be reported.

Now, an irrevocable life insurance trust (ILIT) is a trust created during the insured's lifetime that owns and controls a term or permanent life insurance policy or policies. The trust can also manage and distribute the proceeds that are paid out upon the insured’s death, according to the insured's wishes.

Minimizing Estate Taxes

If you are the owner and insured, then the death benefit of a life insurance policy will be included in your gross estate. However, when life insurance is owned by an ILIT, the proceeds from the death benefit are not part of the insured's gross estate and thus not subject to state and federal estate taxation.

Avoiding Gift Taxes

A properly-drafted ILIT avoids gift tax consequences since contributions by the grantor are considered gifts to the beneficiaries. To avoid gift taxes, it is crucial that the trustee, using a Crummey letter, notify the beneficiaries of their right to withdraw a share of the contributions for a 30-day period. After 30 days, the trustee can then use the contributions to pay the insurance policy premium.

Government Benefits

Having the proceeds from a life insurance policy owned by an ILIT can help protect the benefits of a trust beneficiary who is receiving government aid, such as Social Security disability income or Medicaid. The trustee can carefully control how distributions from the trust are used so as not to interfere with the beneficiary's eligibility to receive government benefits.

Tax Considerations

Irrevocable trusts have a separate tax identification number and an income tax schedule. However, the cash value accumulating in a life insurance policy is free from taxation as is the death benefit. So there are no tax issues with having a policy owned in an ILIT.

Protection Beyond Taxes

An ILIT provides several advantages beyond the ability to provide a tax-free death benefit. This includes protecting your insurance benefits from divorce, creditors, and legal action against you and your beneficiaries. An ILIT also avoids probate and shields assets from expense and loss of privacy during probate.

Downsides of an ILIT

The primary downside of an ILIT is that no changes can be made once the trust is finalized. Whatever is put into the trust is no longer the grantor's. This could have severe implications down the road. For example, if you put a house or a significant amount of cash in a trust with the intent that it will be given to your heir, and then you unexpectedly need those assets in the future, there is nothing you can do about obtaining them.

Frequently asked questions