Life Insurance Proceeds: Virginia's Tax Laws Explained

Life insurance is often seen as a way to provide financial security for loved ones after you're gone, and its tax benefits add to its appeal. Typically, the death benefit your beneficiaries receive isn't taxed, meaning they receive the full amount. However, there are exceptions and unique circumstances that can lead to taxation. This raises the question: are life insurance proceeds taxable in Virginia?

Taxation on cash value life insurance

Cash value life insurance, such as whole or universal life policies, has a savings component that grows over time. This cash value is typically tax-deferred, meaning you don't pay taxes on its growth until you withdraw the money. Policyholders can generally borrow or withdraw from the policy's cash value without immediate tax consequences, as long as the amount withdrawn doesn't exceed what they've paid in premiums. However, if there are outstanding loans against the policy when the insured person dies, those loans will be deducted from the death benefit, reducing the amount paid to beneficiaries.

If the policyholder surrenders the policy or cancels it, the cash value that exceeds the amount paid in premiums is usually taxable as ordinary income. This can result in an unexpected tax bill, especially if the policyholder is unaware of the cash value and loan status.

In the case of modified endowment contracts (MECs), withdrawals are treated differently for tax purposes. Withdrawals are considered taxable income until they equal the total interest earnings in the contract.

When it comes to taxes on beneficiaries, if the beneficiary receives the death benefit in installments, any interest that accumulates on those payments is typically taxed as regular income. Additionally, if the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, the value of the estate may trigger estate taxes, reducing the amount received by heirs.

To avoid potential tax liabilities, some strategies include choosing a lump-sum payout, using an irrevocable life insurance trust (ILIT), keeping policy loans to a minimum, and regularly reviewing and updating beneficiaries.

Life insurance proceeds and estate taxes

Life insurance death benefits are usually tax-free, but there are exceptions.

If the policyholder names their estate as the beneficiary, the person or people inheriting the estate might have to pay estate taxes. This is because the life insurance payout will be added to the value of the estate. If the total value exceeds the federal and state exemptions, any amount over the exemption will be subject to estate and inheritance taxes.

Federal estate taxes apply when the value of an estate exceeds $12.06 million per individual and is subject to a tax rate of up to 40%. State estate and inheritance taxes vary, with 17 states and Washington, D.C., having an inheritance or estate tax. The exemption amount ranges from $1 million to $7 million, and tax rates can be as high as 20%.

To avoid estate taxes, the policyholder can set up an irrevocable life insurance trust (ILIT). By transferring ownership of the policy to an ILIT, the proceeds are not included as part of their estate. However, if the policy's cash value is greater than the gift tax exemption, the policyholder may need to pay a gift tax when transferring ownership. Additionally, if the policyholder dies within three years of transferring the policy to the trust, the policy will likely become part of their estate for tax purposes.

It's important to note that even if the proceeds are taxable, the beneficiary will not receive a 1099 for life insurance proceeds, as the IRS does not consider the death benefit to be income.

Life insurance proceeds and inheritance taxes

Life insurance death benefits are usually not taxable, but there are exceptions.

Estate and Inheritance Taxes

If the policyholder names their estate as the beneficiary, the person or people inheriting the estate might have to pay estate taxes. This is because the life insurance payout is added to the value of the estate. If the total value exceeds the federal and state exemptions, any amount over the exemption is subject to estate and inheritance taxes.

Federal estate taxes apply when the value of an estate exceeds $12.06 million per individual. The tax rate can be up to 40%, depending on the taxable amount.

There are 17 states, plus Washington, D.C., that enforce an inheritance or estate tax. The exemption amount varies by state, ranging from $1 million to $7 million. Tax rates can be as high as 20%.

Avoiding Estate Taxes

One way to avoid estate taxes is to set up an irrevocable life insurance trust (ILIT). This removes the life insurance proceeds from your taxable estate. To do this, you must transfer ownership of the policy to the ILIT and cannot be the trustee. However, you can choose the trust beneficiary.

Another strategy is to choose a lump-sum payout. This keeps the death benefit income tax-free and avoids taxable interest on installment payments.

Other Exceptions

In some cases, taxes may be triggered if the policyholder takes certain actions, such as policy loans or payout installments.

If the beneficiary receives the life insurance payout in installments, any interest that accumulates on those payments will be taxed as regular income.

If the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, this could also trigger estate taxes.

Life insurance proceeds and income tax

Life insurance proceeds are typically not taxable as income, but there are certain situations where taxes may apply.

Interest Accumulation

If the beneficiary receives the life insurance proceeds as a series of installments, any interest that accumulates on those payments is typically taxed as regular income. This is because income earned in the form of interest is usually taxable, and life insurance is no exception. Therefore, while the death benefit itself may not be taxed, the interest generated is considered taxable income.

Estate Taxes

If the policyholder names their estate as the beneficiary instead of an individual, the value of the life insurance proceeds will be included in their taxable estate. This could increase the total value of the estate to a level that triggers estate taxes, reducing the amount that loved ones ultimately receive. Federal estate taxes apply when the value of an estate exceeds a certain threshold, which was $12.06 million for decedents who passed away in 2022 and $12.92 million in 2023. Additionally, some states have their own estate or inheritance tax laws with lower thresholds.

Policy Maturity

Some older life insurance policies mature at a specific age, typically 95 or 100. If the insured individual reaches this age, the policy's cash value may be paid out to the policy owner instead of a death benefit. This payout may be taxed as ordinary income if it exceeds the policy owner's cost basis, which is the sum of the after-tax premiums paid.

Policy Loans and Withdrawals

Permanent life insurance policies, such as whole or universal life, have a cash value component that can be borrowed or withdrawn. Withdrawals up to the cost basis are generally tax-free, but amounts exceeding the cost basis are typically considered taxable income. Similarly, if there are outstanding loans against the policy that exceed the cost basis, they will be treated as taxable income if the policy lapses due to unpaid premiums or insufficient cash value.

Policy Surrender

Surrendering a permanent life insurance policy may result in tax implications if the cash surrender value exceeds the amount of premiums paid. The excess amount is typically taxed as ordinary income.

Policy Sale

Selling a life insurance policy, known as a life settlement, can trigger income and capital gains taxes. The portion of the sale amount that exceeds the cost basis may be subject to income tax, and any amount above the cash value may be subject to capital gains tax.

Dividends

Participating whole life insurance policies may pay dividends that are left in the policy to earn interest. While the dividends themselves are not taxed, the interest earned on those dividends is typically considered taxable income.

State-Specific Taxes

It is important to note that each state has its own set of guidelines regarding taxes on life insurance policies. For example, Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are the only states that currently enforce an inheritance tax, which is a tax on the recipient of any inherited cash payouts, properties, or other assets.

Strategies for Minimizing Taxes

To minimize potential tax liabilities, individuals can consider the following strategies:

• Choose a lump-sum payout to keep the death benefit income tax-free and avoid taxable interest on installments.
• Avoid the "Goodman Triangle" by ensuring that only two parties are involved in the policy (the insured and owner, or the owner and beneficiary) to prevent a gift tax.
• Use an irrevocable life insurance trust (ILIT) to keep the death benefit out of the taxable estate.
• Regularly review and update beneficiaries to ensure the estate is not named as the beneficiary, reducing the risk of estate taxes.
• Monitor policy loans and ensure the policy remains active to prevent taxable income from outstanding loans.
• Transfer ownership of the policy to another person or entity, choosing a competent adult or entity as the new owner.
• Review and plan for potential tax implications with the help of a tax professional.

While life insurance proceeds are generally not taxable, careful planning and consideration of the specific circumstances and state laws can help individuals and beneficiaries avoid or minimize potential tax liabilities.

Life insurance proceeds and irrevocable life insurance trust (ILIT)

Life insurance proceeds are typically not taxable, but there are exceptions. For instance, if the payout is in installments instead of a lump sum, the interest on those payments is taxable. Another exception is when the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary.

One way to avoid these tax complications is by using an irrevocable life insurance trust (ILIT). An ILIT is a type of trust that holds one or more life insurance policies and is created during the insured's lifetime. It is irrevocable, meaning that once it is created, it generally cannot be altered or undone. The main purpose of an ILIT is to decrease the value of an individual's estate, thereby reducing the estate tax paid on the life insurance benefits passed from the grantor to the beneficiary.

• Minimizing estate taxes: When life insurance is owned by an ILIT, the proceeds from the death benefit are not part of the insured's gross estate and are thus not subject to state and federal estate taxation.
• Avoiding gift taxes: A properly-drafted ILIT avoids gift tax consequences since contributions by the grantor are considered gifts to the beneficiaries.
• Protecting government benefits: The trustee of an ILIT can control how distributions from the trust are used, ensuring that they do not interfere with the beneficiary's eligibility to receive government benefits such as Social Security disability income or Medicaid.
• Protection beyond taxes: An ILIT can protect insurance benefits from divorce, creditors, and legal action against the insured and beneficiaries. It also avoids probate, shielding assets from expense and loss of privacy.

Despite these advantages, there are some downsides to consider. Establishing an ILIT requires the grantor to give up all rights to the property in the trust, including who the beneficiaries are and the conditions under which they receive the assets. Additionally, setting up and maintaining an ILIT may incur professional fees and the need to file a gift tax return.

Frequently asked questions