Life Insurance Proceeds: Taxable In North Carolina?

Life insurance is often seen as a reliable way to provide for loved ones after you die, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs, or securing their future. However, there are a few situations where taxes could come into play, and it's important to know when that might happen, especially when it comes to state-specific laws, such as in North Carolina.

Interest accrued on the policy

Life insurance payouts are usually not taxed as income. However, if the policy has accrued interest, taxes are typically due on the interest earned. This means that the amount that earned interest will be taxed, rather than the entire death benefit.

For example, if your loved ones choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. That extra money from interest is considered taxable income, even though the original death benefit is not.

If you have a permanent life insurance policy, you may be able to borrow or withdraw money from the policy's cash value. As long as you don't take out more than you've paid in, these withdrawals are usually tax-free. However, if there are unpaid loans against the policy, they will be deducted from the death benefit, meaning your beneficiaries will receive less.

If you decide to withdraw more than your cost basis (the total amount of premiums you've paid into the policy), the portion that exceeds your cost basis will be considered taxable income and will need to be reported. For example, if you've paid $50,000 in premiums and your policy's cash value has grown to $80,000, withdrawing the full $80,000 would result in $30,000 being considered taxable income.

It's important to carefully consider the tax implications when dealing with life insurance policies that have accrued interest or have a cash value component. By understanding the rules and regulations, you can make informed decisions and potentially minimize tax liabilities.

Estate as beneficiary

In North Carolina, federal and state laws determine the taxability of life insurance proceeds. While life insurance proceeds are generally not taxable, there are exceptions. One such exception is when the policyholder names their estate as the beneficiary.

When a person passes away, their estate includes all the assets they owned at the time of their death. This can include real estate, personal property, and financial assets. The value of the estate is important because it determines whether estate taxes need to be paid. In the United States, there is a federal estate tax exemption, which was $13.6 million in 2024. If the value of the estate exceeds this threshold, estate taxes may be owed.

When a policyholder names their estate as the beneficiary of their life insurance policy, the proceeds become part of the estate. This can increase the value of the estate, potentially pushing it above the federal estate tax exemption threshold. As a result, estate taxes may need to be paid, reducing the amount that loved ones ultimately receive.

It is important to note that estate taxes are not the same as income taxes. Estate taxes are levied on the value of the estate itself, while income taxes are levied on any income generated by the estate. In the context of life insurance, this distinction is important because the proceeds from a life insurance policy are generally not considered taxable income, but they can be included in the value of the estate for estate tax purposes.

To avoid potential estate taxes, it is advisable to name a specific person or entity as the beneficiary of a life insurance policy, rather than the estate. By doing so, the proceeds will pass directly to the beneficiary and will not be included in the value of the estate. This can help maximize the benefit of the life insurance payout for loved ones.

Additionally, it is worth considering other strategies to minimize potential tax liabilities, such as setting up an irrevocable life insurance trust (ILIT). An ILIT owns the life insurance policy, which means the proceeds are not included in the value of the estate. This can be a useful tool for estate planning and ensuring that beneficiaries receive the full benefit of the life insurance payout.

Insured and policy owner are different

In North Carolina, life insurance proceeds are generally not taxable. However, there are some exceptions to this rule. One such exception occurs when the insured and the policy owner are different individuals. In this case, taxes may be involved.

Typically, the person who buys a life insurance policy is considered both the owner and the insured. However, if two different people hold these roles, the death benefit payout may be subject to taxes. This is because the IRS could view the death benefit as a gift from the policy owner to the beneficiary, which would trigger a gift tax if the amount exceeds the annual exclusion limit. This limit was set at $18,0000 in 2024 and $17,000 in 2023.

To avoid this potential tax complication, financial advisors often suggest that only two parties be involved in the policy, with the insured and owner being the same person. This strategy can help to ensure that the death benefit is not taxed as income.

It is important to carefully plan ahead and consider the tax implications when setting up a life insurance policy. By structuring ownership correctly, individuals can safeguard their beneficiaries from unexpected tax burdens. Regularly reviewing and updating beneficiaries as life circumstances change is also crucial to ensure that the policy remains tax-efficient.

Additionally, there are other strategies that can be employed to minimise potential tax liabilities, such as choosing a lump-sum payout instead of installments and using an irrevocable life insurance trust (ILIT). Seeking guidance from a qualified financial advisor can help individuals navigate these complexities and make the most of their life insurance policy while protecting their beneficiaries.

Installments vs. lump sum

Life insurance is divided into two basic categories: term life insurance and permanent life insurance. Term life insurance provides coverage for a specific period, while permanent life insurance provides coverage for the policyholder's entire life. Both types pay a death benefit, which is the amount of money paid out upon the insured's death. This money is typically paid to a beneficiary, such as a spouse, adult children, a charity, a trust, or even a business.

When it comes to receiving the death benefit, beneficiaries usually have the option of receiving a lump sum or installments. Here is a detailed comparison of these two options:

Lump Sum

The lump sum payout is the most common option for life insurance beneficiaries. It gives them full control over the money, and they can use it as they see fit. This option provides the most flexibility, especially if the beneficiary needs to pay off debts, cover funeral costs, or secure their future. However, receiving a large amount of money at once can be overwhelming, and the beneficiary is responsible for making it last. Additionally, if the payout is large, it may need to be spread across multiple bank accounts due to Federal Deposit Insurance Corp. deposit insurance limits.

Installments

With the installment option, the beneficiary receives the death benefit in regular payments over a specified period. This option can be appealing to those who worry about spending a lump sum too quickly. It provides a guaranteed income stream, which can be beneficial for those who need ongoing financial support. However, any interest that accumulates on the installment payments is considered taxable income. As a result, beneficiaries might end up paying more in taxes if the death benefit is high.

In conclusion, the choice between a lump sum and installments depends on the beneficiary's financial needs and preferences. A lump sum offers more flexibility and immediate access to funds, while installments provide a steady income stream but may result in higher taxes. It is important for beneficiaries to carefully consider their options and seek financial advice if needed to make an informed decision.

Gift tax

For 2024, the Federal annual gift tax exclusion amount is $18,000 per individual. This means that you can gift up to $18,000 to one person in a calendar year without having to report it to the IRS. If you are married, this amount can be doubled to $30,000.

The lifetime gift tax exclusion amount is the total amount you can gift during your lifetime without owing any gift tax, although a gift tax return must be filed. For 2024, the Federal lifetime gift tax exclusion amount is $13.61 million per person. Any gifts made above this limit will be taxed at a rate of 40%.

It is important to note that the Estate Tax Exemption and the Lifetime Gift Tax Exemption are linked. Any portion of your Federal Lifetime Gift Tax Exemption used will reduce your available Federal Estate Tax Exemption upon death.

In addition, there are a few common traps that people can fall into when it comes to gift tax. One is future nursing home care and Medicaid eligibility. Just because the IRS allows you to make a gift, does not mean that Medicaid will. If you are concerned about the possibility of future nursing home costs, it is recommended to consult with an elder law attorney before making major gifts.

Another trap is outdated tax planning advice. In the past, tax preparers advised people to give annual gifts to family members to reduce the overall size of their estate and minimize potential estate taxes. However, this is no longer necessary for many people and can backfire if you end up needing nursing home care.

Lastly, liquidating appreciated assets to make a gift can subject you to capital gains taxes that could be avoided if the property was conveyed through your estate planning instead.

Frequently asked questions