Life Insurance Proceeds: Taxable Or Not In The Us?

Life insurance is a valuable tool for personal and business financial planning, and it's natural to wonder whether or not it is taxable. In most cases, life insurance proceeds are not considered taxable income in the US, and beneficiaries can receive the full amount to use for expenses like funeral costs or outstanding debts. However, there are some exceptions where taxes could come into play. For example, if the beneficiary chooses to receive the payout in instalments rather than a lump sum, any interest accrued may be subject to taxes. Additionally, if the policyholder leaves the death benefit to their estate instead of naming a person as the beneficiary, estate taxes may apply if the estate's value exceeds a certain threshold. Understanding the tax implications of life insurance is crucial for effective financial planning.

Interest on life insurance proceeds is taxable

Life insurance proceeds are generally not taxable in the US. When the policyholder of a life insurance policy passes away, the proceeds, or death benefits, are paid to the named beneficiary or beneficiaries. The payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income and is therefore not subject to income or estate taxes.

However, there are some cases when a death benefit can be taxed. One such case is when the payout is structured in multiple payments over the life of the beneficiary. These payments can include proceeds and interest, and the interest is subject to taxes.

The taxation of interest on life insurance proceeds is an important consideration when choosing how to receive the payout. If the beneficiary chooses to receive the payout in installments, they will need to be prepared to pay taxes on the interest that accumulates. This could result in a higher tax burden over time, compared to receiving the payout as a lump sum.

It is important to note that the specific rules and regulations regarding life insurance proceeds and taxes may vary depending on the state and the specific circumstances of the policy. It is always a good idea to consult with a tax professional or financial advisor to understand the tax implications of any life insurance policy.

Surrendering a life insurance policy

Surrendering your life insurance policy means cancelling it and receiving a payout from your insurance company. This payout is known as the cash surrender value, which is the money a policyholder receives for ending their coverage before the policy's maturity date or before they pass away. The cash surrender value is the total sum in the savings component of permanent policies, minus surrender fees and taxes on earnings.

Surrender fees typically range from 10-35% and are usually high in the early years of the policy, phasing out over time. Most policies have a waiting period of at least 15 years before you can surrender them.

When you surrender your policy, you will lose coverage and no longer be responsible for paying insurance premiums. However, you will also lose the death benefit.

There are several reasons why someone might choose to surrender their life insurance policy:

• They no longer need coverage, for example, if their children are grown up and financially independent.
• The insurance premiums are too expensive.
• They have found a better policy that offers improved coverage or cheaper premiums.
• They urgently need cash.

Before surrendering your policy, it is important to consider the pros and cons:

Pros

• It is a simple and quick process.
• You will get some money back, which is better than letting the policy lapse by not paying.

Cons

• You will only get one offer from the insurance company, and it may be a minimal return as they will aim to give you as little money as possible.
• There may be surrender fees of up to 35%.
• You will lose the death benefit.
• You may face tax consequences, as the gain on your policy will be taxed as income.

If you are considering surrendering your life insurance policy, it is important to consult a tax professional to understand the financial implications.

Employer-paid group life insurance

In the US, employer-paid group life insurance is considered a fringe benefit, which is generally included in the employee's gross income. However, Internal Revenue Code (IRC) Section 79 provides an exclusion for the first $50,000 of group-term life insurance coverage provided by an employer. This means that if the total amount of coverage does not exceed $50,000, there are no tax consequences for the employee. The exclusion applies to the cost of the insurance, allowing the same amount to be excluded from the employee's wages for Social Security and Medicare taxes.

On the other hand, if the employer-provided group term life insurance coverage exceeds $50,000, the excess amount is considered taxable income for the employee. This is referred to as "phantom income" because it is included in the taxable wages reported on the employee's Form W-2, even though the employee does not actually receive this amount directly. The cost of the insurance must be determined using a table prepared by the IRS, which may result in a higher taxable amount than the employer's actual cost. This "phantom income" is subject to federal, state, and local taxes, as well as Social Security and Medicare taxes.

It is important to note that the determination of whether the group term life insurance plan is considered "carried" by the employer depends on factors such as whether the plan is discriminatory, how the premiums are paid (employer-paid, employee-paid pre-tax, or employee-paid after-tax), and the specific details outlined in IRC Section 79.

Additionally, the tax consequences of employer-provided life insurance can be mitigated through "carve-out" plans. Employers can offer different types of carve-out plans, such as providing $50,000 of group term insurance (as there are no tax costs for the first $50,000 of coverage) and then offering an individual policy for the remaining balance. Alternatively, the employer can provide the employee with a cash bonus equivalent to the excess coverage cost, allowing the employee to use those funds to pay the premiums on an individual policy.

Payment in installments

In the United States, life insurance proceeds are generally not taxable if you are the beneficiary of the policy. This means that the payout is typically not considered part of the beneficiary's gross income and is not subject to income or estate taxes. However, there are certain situations where taxes may apply, and one of these is when the payout is structured as multiple payments or installments.

When life insurance proceeds are paid out in installments, any interest that accumulates on those payments is typically considered taxable income. This means that while the original death benefit itself is not taxed, the interest earned on the installments will be taxed as regular income. Therefore, beneficiaries should be prepared to report and pay taxes on this interest.

The specific rules regarding the taxation of life insurance proceeds can vary depending on the type of policy, such as term, whole, or universal life insurance. Additionally, there may be other factors that come into play, such as whether the policyholder has withdrawn money or taken out a loan against the policy. It is always a good idea to consult with a tax professional or financial advisor to understand the specific tax implications of your life insurance policy and how they may apply to your individual situation.

To avoid unexpected tax complications, it is recommended to regularly review your policy and ensure that your beneficiary designations are up to date. Proper planning can help minimize potential tax liabilities and ensure that your beneficiaries receive the full benefit of the policy.

Estate as beneficiary

If your estate is the beneficiary of your life insurance policy, the death benefit may be subject to estate taxes. In 2024, the federal estate tax ranges from 18% to 40%, depending on how much of the estate is over $13.61 million, the exclusion limit. Without congressional action, the limit will revert to $5 million (indexed for inflation) at the start of 2026.

In addition to the federal tax, twelve states and the District of Columbia impose an estate tax, with the exemption limit ranging from $1 million in Oregon to $13.61 million in Connecticut.

If the policy doesn't have any named beneficiaries, the life insurance proceeds may be included in the deceased's estate. If the value of the estate exceeds the federal estate tax threshold, which was $13.61 million as of 2024, estate taxes must be paid on the amount that's over the limit. Some states also assess inheritance or estate taxes, depending on the estate's value and where the deceased lived.

It's important to note that regularly reviewing beneficiaries and policy details can help avoid tax complications. Additionally, using strategies such as an irrevocable trust can help minimize potential tax liabilities.

Frequently asked questions