Life Insurance Proceeds: Taxable In South Africa?

Life insurance is a crucial financial product that provides peace of mind and financial security for loved ones in the event of an individual's death. While the primary purpose of life insurance is to offer protection, it's also essential to understand the tax implications surrounding it. In South Africa, the question of whether life insurance proceeds are taxable is a complex one, with various factors coming into play. This includes the type of policy, the structure of the payout, and the specific regulations outlined by the South African Revenue Service (SARS). By understanding these factors, individuals can make informed decisions about their life insurance choices and ensure their beneficiaries receive the maximum benefit.

Taxation on life insurance proceeds in South Africa

Life insurance is a complicated product that combines two of life's certainties: death and taxes. In South Africa, the proceeds from a life insurance policy are generally not taxed, but there are some situations where beneficiaries will have to pay taxes.

In South Africa, the death benefit paid out to beneficiaries is typically not considered taxable income, so the full payout will go to the beneficiaries. Additionally, annual life insurance dividends are also not taxable, as long as the received dividend amount is not more than the sum of the premium payments made in the same year.

There are a few situations where life insurance proceeds may be taxed in South Africa. Here are some common scenarios:

• Interest earned on payout benefits: If the beneficiaries choose to receive the death benefit in installments over time, the insurance company may hold the benefit, which can accrue interest. In this case, the interest earned is taxable.
• Profit from surrendering a cash value policy: If you cancel a cash value life insurance policy, the cash surrender value may be subject to taxation if it is higher than the sum of your premium payments.
• Unpaid loans against your policy: If you allow a policy to lapse or cancel it before repaying a loan taken out against the policy, you may owe taxes on the outstanding balance beyond what you paid into the policy.
• Estate taxes: If your estate is valued above a certain threshold (which varies by year), it may be subject to federal estate taxes. This includes life insurance payouts. To avoid this tax, you can set up an irrevocable life insurance trust (ILIT) or take advantage of the unlimited marital deduction, which allows you to transfer assets to your spouse without estate or gift taxes.
• Generation-skipping transfer tax: If your designated beneficiary isn't a relative, your payout may be subject to the generation-skipping transfer tax. This tax applies to direct gifts that benefit beneficiaries who are not related to you or are one generation younger than you, such as grandchildren.
• Profit from life insurance settlements: If you sell your life insurance policy to someone else for a life insurance settlement, any profit you make on the sale may be taxable.
• Failure to pass a cash value accumulation test: The IRS may consider your life insurance policy an investment subject to income tax if it fails a cash value accumulation test (CVAT). This test analyzes the death benefit against the policy's cash value, and if the cash value is too high, the IRS may require an increase in the death benefit to comply with their revenue code.

It's important to note that tax laws and regulations can change, so it's always a good idea to consult a licensed accountant or advisor to understand the specific tax implications of your life insurance policy in South Africa.

Tax-free death benefit

In South Africa, the proceeds of life insurance policies are generally not taxable. This means that, in most cases, the payout from your life insurance won't be taxed. However, there are some exceptions to this.

Death Benefit Paid Out to Beneficiaries

The death benefit paid out to beneficiaries is typically not considered taxable income, and the full payout will go to the beneficiaries. However, if the estate is valued above a certain threshold (which was $11.58 million for the IRS in 2020), the proceeds of the policy may be subject to federal estate taxes.

Interest Earned on Payout Benefits

If the beneficiary chooses to receive the policy's death benefit in installments over time, the insurance company may hold the death benefit in an account that accrues interest. In this case, while the benefit's principal avoids taxation, any interest earned is taxed.

Endowment Policy

An endowment policy is a type of life insurance that combines the benefits of savings and insurance. The premiums for endowment policies are paid after tax, but the proceeds are tax-free. This makes endowment policies an excellent instrument for forced savings and security for debt.

Retirement Annuity Policy

A retirement annuity policy is another type of life insurance that provides tax benefits. While the premiums are not tax-deductible, a small lump sum is paid out, with a portion of it being tax-free. The rest of the proceeds must be used to fund an annuity for the remainder of the policyholder's life.

Whole or Universal Life Insurance Policy

Whole or universal life insurance policies build cash value over time, and this cash value is not subject to taxation unless the policy is surrendered or transferred to another owner. If the policy is discontinued before maturity, the policyholder can gain access to their accrued cash value minus any surrender fees, and this payout is tax-free as long as it is less than the total amount paid in premiums.

Early Payout for Chronic or Terminal Illness

Many life insurance policies offer an accelerated death benefit rider, which allows the policyholder to access part of their death benefit while alive if they are diagnosed with a chronic or terminal illness. This early payout is not subject to taxation.

Annual Life Insurance Dividends

Some mutual insurance companies, such as Liberty Mutual, State Farm, and New York Life, are owned in part by their policyholders. These policyholders may receive annual dividends on the company's profits, which are not taxable as long as the dividend amount does not exceed the sum of the premium payments made in the same year.

Return of Premium (ROP) Policy

A return of premium (ROP) policy reimburses the policyholder for their paid premiums if they outlive the policy. Since this is considered a refund rather than a payment or profit, the money received is not subject to tax.

Interest earned on payout benefits

In South Africa, life insurance premiums are not tax-deductible. However, as of 2023, the sum paid out to beneficiaries upon the policyholder's passing is tax-free. This tax-free status applies to death benefits, as well as situations where the policyholder becomes seriously ill or disabled.

While the tax-free exception is broad, it primarily applies to death benefit payouts. Secondary products or "bundled offers" with life insurance policies, like cashback options, will most likely not have the same tax privileges. If a policy includes a feature that returns a portion of the premiums after a certain period, this amount may be considered taxable income.

When a life insurance policy pays interest, this income is almost always taxable. If a beneficiary receives life insurance proceeds after a period of interest accumulation, they must pay taxes on the interest, not on the entire benefit. 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.

To avoid paying taxes on life insurance proceeds, a taxpayer can transfer ownership of the policy to another person or entity. Alternatively, they can create an irrevocable life insurance trust (ILIT) to hold the policy, ensuring that they no longer have ownership.

Estate taxes

Estate duty is a type of tax levied on the estate of a deceased person. In South Africa, life insurance pay-outs are not taxable for income tax and capital gains tax purposes. However, they do have an impact on the estate of the deceased and the estate duties.

If no beneficiary is nominated, the pay-out will form part of the deceased's estate, and the estate duty calculation will determine the tax payable. This will increase the value of the estate, which could also increase executor fees payable.

If a beneficiary is nominated, the life insurance payout will be a deemed asset in the estate. This won't increase the value of the estate for executor fee purposes, but it will be considered for estate duty. In this case, the executor of the estate will determine how much the beneficiary will be responsible for paying towards the estate duty.

The estate may attract estate duty if the amount distributed exceeds the estate duty exemption of R3.5 million, or up to R7 million in the case of a second-dying spouse's estate. Estate duty is levied at 20% of amounts that exceed the exemption and at 25% on amounts that exceed R30 million.

It is important to note that the structure of a life insurance policy can affect the payout and the resulting tax implications. For example, policies that are considered South African domestic policies under South African law are subject to estate duty in the estate of the deceased. However, there are instances where proceeds may not be subject to the payment of estate duty, such as when the spouse or partner is the sole beneficiary on the policy.

Life insurance trusts

Life insurance policies are a great way to ensure that your loved ones are financially protected when you're no longer around to take care of them. However, the proceeds from these policies can sometimes be subject to taxation, reducing the amount that your beneficiaries ultimately receive. One way to avoid this tax is by creating an irrevocable life insurance trust (ILIT).

Here's how it works:

How Life Insurance Trusts Work

An ILIT is a legal entity that you create to own your life insurance policy. By transferring ownership of your policy to the trust, you no longer have control over it, and the proceeds are not considered part of your estate for tax purposes. This means that when you pass away, your beneficiaries will receive the full amount of the insurance payout without having to pay any estate taxes.

Advantages of Life Insurance Trusts

There are several advantages to using an ILIT:

• Tax benefits: The main benefit of an ILIT is the tax savings for your beneficiaries. By removing the insurance proceeds from your estate, you can reduce the overall tax burden on your heirs.
• Control: Even though you're no longer the owner of the policy, you can still maintain some control over it by setting up the trust and choosing a trustee to manage it. This can be especially useful if you're concerned about an individual owner failing to pay premiums.
• Protection for minors: If you have minor children, an ILIT allows you to name a trusted family member as trustee, ensuring that the insurance money is managed according to your wishes for the benefit of your children.
• Avoid probate: By naming a trust as the beneficiary of your life insurance policy, you can avoid the probate process, which can be lengthy and costly.

Things to Keep in Mind

There are a few important things to keep in mind when considering an ILIT:

• Three-year rule: The IRS has a three-year rule, which states that if you die within three years of transferring your policy to the trust, the proceeds will still be included in your estate and subject to estate taxes.
• Loss of control: As the grantor of the trust, you give up all rights to make changes to the policy. This means you won't be able to change beneficiaries, borrow against the policy, or cancel it.
• Gift taxes: If the cash value of your policy exceeds the annual gift tax exclusion amount ($17,000 in 2023), you may have to pay gift taxes on the excess amount when you transfer ownership to the trust.
• Complexity: Setting up and maintaining an ILIT can be complex and may require the assistance of a professional.

In conclusion, while life insurance trusts offer several benefits, it's important to carefully consider all the implications and seek professional advice before making any decisions about your life insurance policy and estate planning.

Frequently asked questions