Life Insurance Settlements: Taxable Income Or Tax-Free Windfall?

Life insurance is often seen as a reliable way to provide for loved ones after death. In most cases, the death benefit provided by life insurance is not taxable. However, there are some situations where taxes may be incurred. For example, if the beneficiary chooses to receive the benefit in installments, any interest accrued may be taxed as regular income. Similarly, if the policyholder leaves the benefit to their estate instead of directly to a person, this may trigger estate taxes. Selling a life insurance policy may also result in income and capital gains taxes if the sale amount exceeds the premiums paid. While life insurance proceeds are generally not taxable, careful planning is necessary to avoid potential tax complications.

Life insurance proceeds are typically not taxable as income

Life insurance proceeds are usually exempt from income tax. However, there are some exceptions to this rule.

If the beneficiary of a life insurance policy is an individual, the death benefit is not counted as taxable gross income. However, if the beneficiary is the estate of the deceased, the person or persons inheriting the estate may have to pay estate taxes.

If the beneficiary of the policy is a young child or someone dependent on the income of the deceased, the beneficiary may receive the benefit in installments. In this case, the beneficiary would have to pay income tax on any interest accrued.

If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated during that period.

If the policy is a modified endowment contract (MEC), taxes are different. Withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

If the policyholder named an estate rather than an individual as a beneficiary, the person or people inheriting the estate might have to pay estate taxes.

If the policyholder sells their policy, this may trigger income and capital gains taxes. If the policy is sold for more than the amount paid in premiums, the gain on that amount could be taxed.

Life insurance proceeds are not normally subject to estate or income tax. However, associated taxes related to interest earned during the collection process can be minimised by ensuring the proper documentation and reporting requirements are met in a timely manner.

Life insurance settlements are taxable to the extent you make a profit

Life insurance settlements are taxable, but only to the extent that you make a profit. This means that if you sell your life insurance policy for more than you paid in premiums, the gain on that amount could be taxed. The portion of the sale amount that you receive that is equal to what you've paid in premiums (your "cost basis") will not be taxed. However, any amount above this cost basis may be subject to income tax or capital gains tax, depending on how your cost on the policy compares to the policy's cash surrender value when it was sold.

The Tax Cuts and Jobs Act of 2017 (TCJA) simplified the taxation of life settlements by defining the profit of your life settlement as the difference between the premiums you paid and the cash payout you received from the sale. This clarification was welcomed by policyholders and tax specialists, who had previously found the IRS's approach to calculating profit on life settlement contracts vague and difficult to understand.

It's important to note that the taxation of life settlements can be complex, and the rules have changed over time. Consulting with a tax professional is always recommended to ensure you're complying with the latest regulations and minimizing your tax liability.

Interest on life insurance proceeds is taxable

Life insurance proceeds are generally not taxable if you are the beneficiary receiving them due to the death of the insured person. However, interest on life insurance proceeds is taxable. If you receive life insurance proceeds as a beneficiary, any interest that you receive on top of the benefit is taxable and should be reported. This is the case even if the death benefit itself is not taxed.

The IRS treats interest on life insurance proceeds as taxable income, and the interest must be reported when filing taxes. This is separate from the life insurance proceeds, which generally do not need to be reported as income. It is important to understand the tax implications of receiving life insurance proceeds to ensure compliance with tax laws and to avoid unexpected tax burdens.

The taxation of life insurance proceeds can be complex, and there may be other factors that come into play depending on the specific situation. For example, if the policy was transferred to the beneficiary in exchange for cash or other valuable consideration, the exclusion for the proceeds may be limited. In such cases, it is generally recommended to consult with a tax professional or financial advisor to understand the specific tax implications.

Estate taxes may apply if the amount being passed to heirs exceeds federal and state exemptions

In 2024, the federal estate tax exemption limit is $13.61 million for an individual. This means that if you die in 2024 and the total taxable value of your assets is greater than this amount, the IRS will levy an estate tax. If you die while holding a life insurance policy, the IRS will count the payout in the value of your estate – regardless of whether you name a beneficiary. The payout could push your estate’s total taxable value over the limit, and your heirs would have to pay an estate tax on any assets above the threshold within nine months of your death.

If you have a will or trust in place and name your estate as the beneficiary of your policy, the life insurance payout can be used to pay estate taxes. But if you choose one or more individuals as beneficiaries, they won’t be held liable for estate tax – they will receive the life insurance payout tax-free, and estate taxes will be paid from other assets you owned.

In addition to federal estate taxes, some states levy estate or inheritance taxes. Exemption limits vary among states. For example, New York's estate tax kicks in after $6.94 million. Talk to a tax professional to learn how life insurance can affect estate taxes in your state.

If you are a high net worth individual with a sizable estate, you can keep your life insurance death benefit from being counted as part of your estate by transferring ownership to an irrevocable life insurance trust, or ILIT, and paying premiums out of the trust account. This puts the policy and the disbursement of the payout under the trust’s control, so it’s excluded from the value of your estate.

With ILITs, the rules are complex and must be followed to the letter. For example, the three-year rule states that a policy is still part of your estate if a transfer of ownership occurs within three years of your death.

Surrendering your life insurance policy may trigger taxes

If you have a term life insurance policy, which does not have a cash value component, you won't receive any money from the insurer if you surrender the policy. However, if you have a permanent life insurance policy, such as whole or universal life insurance, your policy has likely accrued cash value over time. This cash value is essentially how much money you would receive if you decided to surrender the policy.

When you surrender a permanent life insurance policy, you are cancelling the coverage, and the insurer will pay out the policy's cash surrender value, minus any surrender fees. If the cash surrender value is greater than the amount you have paid in premiums, the difference will be taxable as ordinary income. This is because the IRS considers the additional cash value as income and taxes it accordingly. For example, if you surrender a $10,000 policy and the policy basis (the total amount of premiums you've paid) is $5,000, the IRS will tax the additional $5,000 as income.

It's important to note that surrendering your life insurance policy may not be the most financially advantageous option, as you will likely receive a lower payout compared to selling your policy or keeping it active. Consulting a tax professional can help you understand the tax implications of surrendering your life insurance policy and explore alternative options.

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