Life Insurance Proceeds: Massachusetts Tax Laws Explained

Life insurance is a financial product that provides financial protection for your family in the event of your death. In Massachusetts, the proceeds of life insurance are generally not taxable, but there are some specific circumstances in which they can be. For example, if the payout is structured as multiple payments, these can be taxable. Similarly, if the policyholder has withdrawn money or taken out a loan, and the amount withdrawn exceeds the total amount of premiums paid, this may also be taxable.

Proceeds paid in a lump sum are tax-free

In Massachusetts, proceeds from life insurance are generally income tax-free. This means that if you are a beneficiary of a life insurance policy, you do not have to pay taxes on the payout. The death benefit is generally not included in the beneficiary's taxable income. This applies to term, whole, and universal life insurance policies.

However, it is important to note that there are some exceptions to this. If the payout is structured as multiple payments, such as an annuity, these payments can be subject to taxes. This is because the payments include proceeds and interest, and the interest is taxable to the beneficiary. Additionally, if the policyholder has withdrawn money or taken out a loan against the policy, and the amount withdrawn exceeds the total amount of premiums paid, the excess may be taxable.

Similarly, if you surrender your life insurance policy, any funds over your policy's cash basis will be taxed as regular income. In the case of an employer-paid group life plan, a payout of more than $50,000 may be taxable according to the Internal Revenue Service (IRS).

It is also important to consider estate taxes. While life insurance proceeds are not subject to income or estate taxes, they may be included as part of the deceased's estate. If the total value of the estate, including life insurance proceeds, exceeds the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. As of 2023, the federal estate tax threshold is $12.92 million. In Massachusetts, if the gross estate exceeds $1,000,000, a state estate tax return must be filed, and the maximum tax rate is 16%.

To avoid estate taxes, life insurance can be established under an Irrevocable Life Insurance Trust (ILIT). This removes the life insurance policy from the estate by changing the ownership of the policy to a trust. The beneficiaries of the trust remain the same as those of the life insurance policy. While an ILIT can provide significant tax advantages, it is important to consider the drawbacks, such as the loss of control over the policy and the need for a lawyer to navigate the complex process.

Proceeds paid in instalments are taxable

In Massachusetts, proceeds from life insurance are generally income tax-free. If you name a spouse, child, or any other individual as a beneficiary to a life insurance policy you own, they will not have to report any of the proceeds as income upon your death.

However, if the beneficiary elects to receive the death benefit in instalments instead of a lump sum, the interest portion of the payments is taxable as ordinary income. For example, if the payout is set up to be paid in multiple payments, these payments can be taxable. An annuity is paid regularly over the life of the beneficiary, including proceeds and interest, and these payments can be subject to taxes.

If a beneficiary keeps the proceeds with the insurer instead of taking receipt, and the proceeds are held in a savings account, any interest earned on the balance would also be taxable. Insurers may use terms such as "assurance" or "access" to market these types of accounts. It is always important to comparison shop and review any administrative or maintenance fees.

The income tax-free nature of life insurance makes it a valuable tool for family protection, liquidity, and wealth transfers. However, it is important to incorporate life insurance details into a complete financial plan to avoid any missteps or missed opportunities that could impact the tax treatment of life insurance.

Surrendering a policy

Surrendering a life insurance policy means cancelling the policy and receiving a payout. This payout is known as the cash surrender value.

When to Surrender a Policy

The cash surrender value is generally lower than the cash value of the policy, as the insurer will take out surrender fees, administrative fees, and any outstanding loans. Surrendering a policy early on can lead to significant fees, so it is worth looking into how your insurer handles surrendering, as well as what other options are available, before making a decision.

How to Surrender a Policy

To surrender your life insurance policy, first review your policy documents and gather the relevant paperwork. Then, contact your insurer to inform them of your intention to surrender the policy. They will guide you through their specific process, which may include a letter of intent or a surrender form. Once your insurer processes the request, you should receive the cash surrender value for your policy.

Tax Implications

Some of the funds from surrendering a life insurance policy may be subject to income tax. The money you pay in (the cost basis) won't be taxed, but anything you receive over what you paid in is taxable.

Employer-paid group life plans

In Massachusetts, an employer-paid group life plan that pays out more than $50,000 may be taxable according to the Internal Revenue Service (IRS). If the payout is less than $50,000, the death benefit is paid to the beneficiaries tax-free. This is in accordance with federal income tax purposes, where an employee's gross income includes an amount equal to the cost of group term life insurance provided by the employer, but only if the cost exceeds the sum of the cost of $50,000 of such insurance and the amount paid by the employee toward the insurance purchase.

For federal income tax reporting, the cost of group-term life insurance taxable to an employee is considered compensation and is reported as wages on line 7 of Form 1040, United States Individual Income Tax Return. In Massachusetts, this amount is then entered on line 10 of the employee's Massachusetts Individual Income Tax Form 1.

It is important to note that the tax treatment of life insurance can be complex, and there may be other factors that come into play. For example, if the beneficiary elects to receive the death benefit in installments instead of a lump sum, any interest portion of the payments is taxable as ordinary income. Additionally, life insurance may be taxable as part of an estate if the policy is controlled by the deceased in any way. This is known as an incident of ownership of the policy, and the proceeds may be subject to estate taxes.

To avoid unexpected tax consequences, it is always recommended to seek advice from a qualified tax advisor or legal counsel, especially when dealing with specific situations or complex instruments such as an Irrevocable Life Insurance Trust (ILIT).

Estate taxes

In Massachusetts, life insurance proceeds are generally not taxable if received as a lump sum. However, if included as part of the deceased's estate, life insurance proceeds may be subject to estate taxes if the total value exceeds the state's exemption threshold.

To mitigate potential estate tax liabilities, residents of Massachusetts can consider establishing an Irrevocable Life Insurance Trust (ILIT). An ILIT effectively removes the life insurance policy from the estate by transferring ownership to a trust, preserving the tax-free nature of the life insurance proceeds for the beneficiaries. While an ILIT can provide significant tax advantages, it also comes with certain drawbacks, such as the loss of control over the policy, the need for a lawyer to navigate the complex setup process, and limitations on how the policy can be used.

It is important to note that estate planning and tax laws can be complex and subject to change. Therefore, it is always recommended to consult with a qualified tax advisor or estate planning attorney to discuss specific situations and explore the most appropriate strategies for managing estate taxes.

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