Life Insurance Proceeds: Are They Taxable In Connecticut?

Life insurance is a valuable financial tool that provides peace of mind and financial security for individuals and their loved ones. While the primary purpose of life insurance is to offer protection and support in the event of unforeseen circumstances, it's also important to understand the tax implications associated with these policies. In Connecticut, residents and property owners must navigate not only federal tax laws but also the state's unique estate and gift tax regulations. So, are life insurance proceeds taxable in Connecticut?

Connecticut's estate tax

In Connecticut, if you leave behind more than $13.61 million, your estate might owe Connecticut estate tax. This applies to both state residents and non-residents who own real estate or other tangible assets in Connecticut.

The Connecticut estate tax is separate from the federal estate tax, which has the same exemption threshold for 2024. Prior to 2023, the Connecticut exemption was lower than the federal exemption, meaning estates that weren't large enough to owe federal estate tax may have still owed Connecticut estate tax.

The Connecticut estate tax return, CT-706, must be filed after the death of the estate owner, regardless of the size of their estate. Estates over $13.61 million will need to file the tax return with the Connecticut Department of Revenue Services, while estates smaller than that will need to file with the Connecticut Probate Court.

The taxable estate of a Connecticut resident with a value of more than $9.1 million will owe estate tax, and the personal representative of the estate must file CT-706 with the Connecticut Department of Revenue Services. The taxable estate is calculated by subtracting any allowable deductions from the gross estate, which includes:

• Bank and investment accounts (retirement and non-retirement)
• Vehicles and other items of personal property
• Proceeds from any life insurance policies on the estate owner's life, if they owned the policies
• Business interests
• Property held in a revocable living trust

The estate may be able to take certain deductions, such as:

• Marital deductions: Property left to a surviving spouse, regardless of the amount, can be deducted from the gross estate.
• Charitable deductions: Gifts to qualified public, charitable, and religious organisations can be deducted from the gross estate.
• Debts and administration expenses: Debts owed and some administration expenses (e.g. funeral costs and attorney's fees) can be deducted from the gross estate.
• Co-ownership: If the estate owner owned assets with someone else, generally only their share will be included in their estate.

Connecticut's gift tax

Connecticut is the only state in the US that imposes a state-level gift tax. The Connecticut gift tax rate is 11.6% if the value of the taxable estate/gift is $9.1 to $10.1 million, and 12% if the value is over $10.1 million. The annual exemption is $16,000 per person, and $32,000 per couple. This means that an individual can gift up to $16,000 to as many people as they want without triggering the requirement of filing a gift tax return or paying any gift tax. The lifetime tax-free exemption is $9.1 million.

In comparison, the federal gift tax rate is 40%, with an annual exemption of $16,000 per person, and a lifetime tax-free exemption of $12.06 million.

It's important to note that there are certain types of gifts that are not subject to the gift tax, such as charitable gifts to registered nonprofit organizations, money given to a spouse who is a US citizen, money for medical expenses, and money to cover education tuition.

The Connecticut gift tax exemption is expected to increase in 2023 to $12.92 million, and the annual exclusion will increase to $17,000. However, in 2026, the lifetime and estate exemptions are expected to drop to around $6 million.

Interest on life insurance proceeds

Life insurance proceeds are generally not taxable. However, interest accrued on the proceeds is taxable and must be reported as such.

If the beneficiary of a life insurance policy receives the death benefit as a lump sum, it is not counted as taxable gross income. However, if the payout is delayed and the money is held by the life insurance company for a period, the beneficiary may have to pay taxes on the interest generated during that time.

The IRS states that if the life insurance policy was transferred for cash or other assets, the amount that can be excluded from gross income when filing taxes is limited to the sum of the consideration paid, any additional premiums paid, and certain other amounts. This means that you cannot overpay for a policy as a way to reduce your taxable income.

In the case of whole life insurance, each premium payment contributes to the policy's cash value, which grows over time. This cash value can be borrowed against or withdrawn, but if the withdrawal or loan exceeds the total amount of premiums paid, the excess is subject to taxation.

If you surrender a whole life insurance policy, you will typically receive the cash surrender value, which is the policy's cash value minus any fees. While you don't have to pay taxes on the principal amount, any cash value the policy has accrued will be taxed as income.

To avoid paying taxes on life insurance proceeds, you can transfer ownership of the policy to another person or entity. Another option is to set up an irrevocable life insurance trust (ILIT) and transfer ownership of the policy to the trust. However, as the original owner, you must forfeit any legal rights to the policy and cannot be the trustee.

Withdrawing money from cash value

Withdrawing money from the cash value of a life insurance policy is a way to access cash from permanent life insurance policies, such as whole life or universal life insurance, while the policyholder is still alive. This is one of the benefits of a permanent policy, which is why it costs more than a term life insurance policy.

There are several ways to withdraw money from the cash value of a life insurance policy. One way is to take out a loan against the cash value. This option allows the policyholder to keep their coverage and the loan is guaranteed by the policy, so no credit or income checks are required. Interest rates on these loans are typically lower than those on home equity or personal loans, and the loan terms are more flexible. However, the interest on the loan must be paid back, and if the policyholder dies before paying off the loan, the outstanding balance will be deducted from the death benefit received by the beneficiary.

Another way to withdraw money from the cash value of a life insurance policy is to make a partial withdrawal. Withdrawals can be made up to the amount that has been paid in premiums without incurring taxes on the funds. Withdrawing more than the total amount of premiums paid will result in taxes on the excess amount. Withdrawals will also reduce the death benefit, and may even reduce it by more than the amount withdrawn, depending on the policy.

Surrendering a life insurance policy

The cash surrender value is not the same as the cash value of a policy, which is the total sum in the savings component of permanent policies like whole and universal life insurance. The cash surrender value is lower than the cash value due to surrender fees, which typically range from 10-35%. These fees are usually highest in the early years of the policy and then gradually decrease over time. Most policies also have a waiting period of at least 15 years before you have the option to surrender them.

When you surrender a life insurance policy, you will lose coverage and no longer be responsible for paying insurance premiums. However, you may have to pay surrender fees for cancelling your coverage early, which will be deducted from any cash value your policy has or paid out of pocket if you have a term policy. You may also have to pay taxes on the surrender value if your earnings exceed the amount you have paid into the policy.

For example, if you have paid $20,000 in premiums but your policy has a cash value of $30,000, you will need to pay taxes on the $10,000 in earnings. The amount of tax you will pay depends on your income bracket, but let's say it's 22%. In this case, you would pay $2,200 in tax, leaving you with a cash surrender value of $27,200 before fees. If surrender fees are 20%, this would be a further $5,440 deduction, leaving a final cash surrender value of $21,760.

There are several reasons why someone might choose to surrender a life insurance policy. These include:

• No longer needing coverage (e.g. because children have grown up and become financially independent)
• Unaffordable insurance premiums
• Finding a better policy that offers improved coverage or cheaper premiums
• Needing cash quickly to cover urgent expenses

However, it is important to consider the pros and cons of surrendering a life insurance policy, as it is a significant decision that will affect you and your family.

Pros of Surrendering a Life Insurance Policy

• Easy and fast: Surrendering your policy is a simple and quick process, as the insurance company will give you an offer and you can choose to accept or reject it.
• Get some money back: Surrendering your policy means you will receive some money, which is better than getting nothing if you were to let the policy lapse.

Cons of Surrendering a Life Insurance Policy

• Minimal return: Insurance companies will aim to give you as low an offer as possible, so you may get a better deal by selling your policy instead.
• Surrender fees: Insurance carriers often charge fees for surrendering a policy, which can be as high as 10-35% of the proceeds.
• Limited options: When surrendering a policy, the insurance company will give you a single take-it-or-leave-it offer, with no room for negotiation.

Frequently asked questions