Life Insurance Proceeds: Are Employer-Paid Benefits Taxable?

Life insurance is a financial product that pays out a lump sum in the event of the insured's death, providing financial support to their beneficiaries and heirs. When an employer provides life insurance as part of an overall compensation package, the Internal Revenue Service (IRS) considers it income, which means the employee is subject to taxes. However, these taxes only apply when the employer pays for more than $50,000 in life insurance coverage. The premium cost for the first $50,000 in coverage is exempt from taxation.

Proceeds are generally tax-free for beneficiaries

Life insurance is intended to support one's beneficiaries, so the IRS treats it differently from other types of financial products. Generally, life insurance proceeds received by a beneficiary due to the death of the insured are not taxable income and do not need to be reported to the IRS. This is because the proceeds are not considered to be included in the beneficiaries' taxable income.

However, there are some exceptions to this rule. Firstly, if the policy was transferred to the beneficiary 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. Secondly, if the beneficiary is an estate, the death benefit may be subject to estate taxes if the estate is worth more than the maximum threshold allowed, which is $11.7 million at the federal level. In addition, twelve states and the District of Columbia impose an estate tax, with exemption limits ranging from $1 million in Oregon to $13.61 million in Connecticut. Thirdly, if the beneficiary lives in one of the six states that enforce an inheritance tax (Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania), they will be taxed on any inherited cash payouts, properties, and other assets. Lastly, if the beneficiary is receiving the proceeds in installments, any interest that accrues is taxable, although the principal death benefit is not.

Interest on proceeds is taxable

Generally, life insurance proceeds are not taxable if you are the beneficiary of the policy. However, if you receive life insurance proceeds as part of your salary or compensation package from your employer, the amount above $50,000 is considered taxable income.

Interest on life insurance proceeds is taxable and must be reported as such. This includes interest on installment payments and interest on dividends earned from participating whole life insurance policies. If you choose to receive life insurance proceeds in installments, any interest accrued on those payments is considered taxable income.

If you have a whole life insurance policy, the interest generated is not taxed until the policy is cashed out. However, if you withdraw more than you have paid in premiums, the amount withdrawn above your cost basis is considered taxable income. This also applies to universal life insurance policies.

It is important to note that life insurance proceeds can become part of your taxable estate if you do not name a beneficiary. In such cases, the proceeds may be subject to estate taxes if your estate's total value exceeds the federal estate tax exemption.

Employer-paid life insurance is taxable above $50,000

Life insurance is a financial product that pays out a lump sum to beneficiaries and heirs in the event of the policyholder's death. While the proceeds from a life insurance policy are generally not taxable, there are certain circumstances in which they can be taxed. One such scenario relates to employer-paid life insurance.

When an employer provides life insurance as part of an employee's compensation package, the Internal Revenue Service (IRS) considers it as income. This means the employee is subject to taxes on the premium paid for the policy. However, these taxes only apply when the employer-paid coverage exceeds $50,000. The premium cost for the first $50,000 of coverage is exempt from taxation. For example, if an employer provides an employee with a $100,000 life insurance policy, the employee must pay taxes on the portion above the $50,000 threshold. The taxable amount is based on IRS tables and varies depending on factors such as the age of the insured.

It is important to note that the taxation of employer-paid life insurance only applies when the coverage amount exceeds the $50,000 threshold. If the coverage is $50,000 or less, the employee does not have to pay any taxes on the life insurance benefit. Additionally, life insurance proceeds received by beneficiaries due to the death of the insured are generally not considered taxable income and do not need to be reported to the IRS.

The taxation of employer-paid life insurance is a specific scenario outlined by the IRS. There are other situations where life insurance proceeds may be taxable, such as when the cash value of the policy exceeds certain thresholds, triggering estate or generation-skipping taxes. Consulting a tax professional or financial advisor can help individuals understand the tax implications of their specific life insurance policies.

Estate tax applies if proceeds are part of an estate worth over $11.7 million

Generally, life insurance proceeds are not taxable if you are the beneficiary. However, if the proceeds are included as part of your estate, estate tax may apply if your estate exceeds a certain value.

Estate tax is a tax on your right to transfer property upon your death. According to the Internal Revenue Code, 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 of the policy at the time of your death.

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. For 2024, the exemption threshold is $11.7 million at the federal level, meaning that any amount above this value may be subject to estate tax.

It is important to note that estate tax is different from inheritance tax, which is imposed on the recipient of the inherited cash payouts, properties, or other assets. Only a few states in the US, such as Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania, enforce this tax.

To avoid federal estate taxes on life insurance proceeds, you can transfer ownership of the policy to another person or entity or create an irrevocable life insurance trust (ILIT). By doing so, the proceeds are not included as part of your taxable estate. Consulting with a tax professional can help you navigate these complexities and make informed decisions.

Surrendering a policy may result in tax on cash value

Surrendering a life insurance policy means that you're terminating the policy. You may no longer want or need it, or you want the cash value built up in the contract. This option usually applies to permanent life insurance policies, such as whole life or universal life insurance. These policies typically accumulate cash value over time, which factors into the surrender value.

When you surrender a policy, you receive whatever you paid in premiums back tax-free. However, if you receive more than you paid in total premiums, you may owe income tax on your earnings. The Internal Revenue Service (IRS) considers the surrender of a life insurance policy a taxable event if the surrender value is more than the premiums you've paid.

The taxable amount, subject to ordinary income tax, is the difference between the cash surrender value minus the total premiums paid. This information can be found on your latest policy statement or by contacting your insurance company.

For example, if you have paid $50,000 in premiums over the life of your policy and the cash surrender value is $70,000, the taxable gain when surrendering your policy would be $20,000. The percentage you'll owe in taxes is whatever your current tax bracket is.

It's important to note that surrender fees may also apply. These are extra charges that the insurance company deducts from your cash value component if you surrender the policy before a specified number of years, usually around ten. While each company is different, surrender fees often start at 10% in Year 1 and then reduce by 1% each year until dropping to 0% in Year 10.

In addition to surrender fees, there are other scenarios that may result in potential tax consequences when you surrender your policy:

• You receive more funds than the policy's cost basis.
• You have outstanding policy loans that exceed the policy's cost basis.
• Your cost basis changed while you had the policy, such as reducing the death benefit or adding riders.

Before surrendering your life insurance policy, it's recommended to consult with a tax expert and financial advisor to understand the potential tax implications and explore alternative options.

Frequently asked questions