Life Insurance Payouts: Taxable Business Income?

Life insurance proceeds are typically not taxable as income, but there are exceptions. For example, if the beneficiary receives the payment in installments, the insurer will pay interest on the outstanding death benefit, which is taxable. Additionally, if the policy is owned by a third party, the beneficiary may be taxed. If the policyholder surrenders the policy for cash, the proceeds may be taxable. Life insurance proceeds can also be taxed as part of your estate if the amount passed to heirs exceeds federal and state exemptions.

Naming an estate as beneficiary

Naming an estate as a beneficiary is a common mistake when it comes to life insurance. While it is possible to name your estate as a beneficiary, it is important to be aware of the disadvantages of doing so.

Firstly, naming your estate as a beneficiary may result in probate, which can cause delays in the distribution of the death benefit. The proceeds will become an asset of the probate estate and will be subject to all the costs associated with settling an estate, including taxes, administrative costs, attorney fees, and executor fees. This can result in higher costs and longer wait times for your beneficiaries to receive their inheritance.

Additionally, in many states, naming your estate as a beneficiary may expose the life insurance proceeds to the claims of creditors. This means that the proceeds could be used to pay off any outstanding debts you may have at the time of your death, reducing the amount available for your intended beneficiaries.

To avoid these potential issues, it is often recommended to name a trust as the beneficiary of your life insurance policy. Proceeds distributed to a carefully constructed trust will be shielded from the claims of creditors and will not be included in the probate estate, resulting in a faster and more efficient distribution of the death benefit to your intended beneficiaries.

It is crucial to carefully consider your options and seek professional advice when designating a beneficiary for your life insurance policy to ensure that your wishes are carried out in the most efficient and effective manner.

Transferring ownership

Life insurance proceeds are generally not taxable if you are the beneficiary. However, if the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts.

There are two main ways to transfer ownership of a life insurance policy:

• Transferring ownership to another adult: This can be the named beneficiary of the policy. After the transfer, the new owner is responsible for making all premium payments. This method is irreversible, so careful consideration is needed when choosing the new owner.
• Creating an irrevocable life insurance trust (ILIT): The policy is transferred to the trust, and you are no longer considered the owner. This method allows you to maintain some control over the policy and ensure that all premiums are paid promptly. It also helps to avoid the three-year rule, which states that gifts of life insurance policies made within three years of death are subject to federal estate tax.

When transferring ownership, it is important to remember that the original owner must give up all rights to make changes to the policy, including changing beneficiaries, borrowing against the policy, or cancelling it. Additionally, the original owner should not continue to pay the premiums, as this may be seen by the IRS as evidence that they are still the true owner.

Creating an irrevocable life insurance trust (ILIT)

An irrevocable life insurance trust (ILIT) is a legal arrangement that seeks to minimise your current tax burden and the impact of taxes on your estate. It is created during the insured's lifetime and owns and controls a term or permanent life insurance policy. The trust can also manage and distribute the proceeds that are paid out upon the insured's death, according to their wishes.

The parties in an ILIT are the grantor, trustees, and beneficiaries. The grantor typically creates and funds the ILIT. The trustee manages the ILIT, and the beneficiaries receive distributions. It is important for the grantor to avoid any incident of ownership in the life insurance policy. Any premium paid should come from a checking account owned by the ILIT.

There are several benefits to setting up an ILIT:

• Minimising estate taxes: If you are the owner and insured, 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 notifies 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.
• Protection from creditors: Although each state has its own rules regarding exactly how much of the insurance policy cash value or death benefit can be protected from creditors, when the policy is held in an ILIT, any excess value above those limits is generally protected from the creditors of both the grantor and the beneficiary.
• Protection of legacy assets: An ILIT can be an effective mechanism for protecting legacy assets from potential creditors.
• Protection of government benefits for family members with special needs: For those seeking to provide lifetime care for a family member with special needs, careful estate planning is essential. Using an ILIT can help ensure that inherited assets don't inadvertently interfere with a beneficiary's eligibility for government benefits.
• Protection from probate: An ILIT avoids probate and shields assets from expense and loss of privacy during probate.

The main downside of an ILIT is that it is irrevocable. A revocable trust can be easily modified or terminated because the assets remain the property of the grantor. However, you relinquish control over assets when you gift them to an irrevocable trust. Therefore, the trust cannot be modified without legal action or the consent of the beneficiaries.

Interest on proceeds

Life insurance proceeds are generally not taxable as income. However, if the beneficiary receives the payment in a series of installments, the insurer will pay interest on the outstanding death benefit. This interest is taxable.

If the beneficiary is a young child or someone dependent on the income of the deceased, they may request to receive the life insurance death benefit in installments. In these cases, the beneficiary must pay income tax on the interest. For example, if a death benefit of $500,000 earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth.

The IRS states that if the life insurance policy was transferred for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. There are exceptions to this rule, and generally, the taxable amount is based on the type of income document received, such as a Form 1099-INT or Form 1099-R.

Life insurance proceeds can be taxable as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. Federal estate taxes apply when the value of an estate exceeds $12.06 million per individual and is subject to a tax rate of up to 40%. Additionally, there are 17 states, plus Washington, D.C., with an inheritance or estate tax, with exemption amounts ranging from $1 million to $7 million and tax rates as high as 20%.

One way to avoid life insurance payouts being taxed as part of your estate is to set up an irrevocable life insurance trust (ILIT). However, if the life insurance policy's cash value is greater than the gift tax exemption when setting up the trust, a gift tax may need to be paid when transferring ownership. As of 2022, the gift tax exemption is $16,000. Additionally, if the insured dies within three years of transferring the policy to the trust, the policy will likely become part of the estate for tax purposes.

While life insurance proceeds are typically not taxable, there are situations where taxes may apply, such as when the beneficiary receives the payout in installments or when the proceeds are included in the value of the estate. By understanding these exceptions, beneficiaries can be prepared for any potential tax liabilities and take steps to minimize them, such as by setting up an ILIT.

Estate taxes

Life insurance proceeds are generally not considered taxable income for the beneficiary. However, there are certain situations where taxes could come into play, especially when it comes to estate taxes. Here's what you need to know about life insurance proceeds and estate taxes:

• Naming your estate as the beneficiary: One common mistake is naming "payable to my estate" as the beneficiary of a life insurance policy. This takes away the advantage of naming a person and subjects the proceeds to the probate process, increasing the value of your estate. As a result, your heirs may be subject to high estate taxes.
• Section 2042 of the Internal Revenue Code: According to this section, the value of life insurance proceeds insuring your life is included in your gross estate if the proceeds are payable to your estate or to named beneficiaries if you had any ownership rights to the policy at the time of your death.
• The three-year rule: The IRS has a three-year rule that applies to the transfer of ownership of life insurance policies. If you transfer ownership of your policy within three years of your death, the proceeds will still be included in your estate and subject to federal estate tax.
• Exemption amounts: The Tax Cuts and Jobs Act (TCJA) of 2017 set the exemption amount at above $12.06 million for 2022 and $12.92 million for 2023, with a top tax rate of 40%. However, not all estates are subject to taxes.
• Strategies to reduce estate taxes: To avoid federal taxation on life insurance proceeds, you can transfer ownership of your policy to another person or entity, such as an irrevocable life insurance trust (ILIT). This removes the proceeds from your taxable estate. It's important to do this well in advance, as it's an irrevocable event and you'll need to give up all rights to make changes to the policy.

In summary, while life insurance proceeds are generally not taxable for the beneficiary, they can become part of your taxable estate, potentially triggering estate taxes. Careful planning, such as transferring ownership or using trusts, can help minimize these tax implications and ensure your heirs receive the maximum benefit.

Frequently asked questions