Alyssa Lane
Life insurance is often seen as a way to provide financial security for loved ones after you're gone. While the death benefit your beneficiaries receive from a life insurance policy is typically not taxed as income, there are some situations where taxes may apply. So, are taxes automatically withheld from life insurance payouts? The answer is, it depends.
What You'll Learn
Interest on life insurance payout is taxable
Life insurance payouts are generally not taxable, but there are some exceptions. One such exception is interest on life insurance payouts, which is considered taxable income. If you receive a life insurance payout in installments, any interest that accumulates on those payments will be taxed as regular income. This means that while the death benefit itself is not taxed, the interest that builds up on those payments is considered taxable income. Therefore, beneficiaries should be prepared to report the interest on their taxes.
The Internal Revenue Service (IRS) states that any interest received from a life insurance payout is taxable and should be reported as interest received. This is separate from the life insurance proceeds, which are generally not includable in gross income and do not need to be reported. However, there are some cases where the proceeds may be taxable. For example, if the policy was transferred to the beneficiary for cash or other valuable consideration, the exclusion for the proceeds may be limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. In this case, the taxable amount is generally reported based on the type of income document received, such as a Form 1099-INT or Form 1099-R.
To protect your policy and avoid unexpected tax liabilities, it is important to understand the different types of taxes that may apply to life insurance payouts. In addition to income tax, life insurance payouts may be subject to estate tax, inheritance tax, or generation-skipping tax in certain circumstances. Consulting with a tax professional can help ensure that all tax obligations are met and that your beneficiaries receive the maximum benefit.
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Estate tax
An estate tax is a tax on your right to transfer property upon your death. Your life insurance proceeds may be taxable if your estate is worth more than the maximum threshold allowed. The federal threshold for exemption is $12.06 million for 2022 and $12.92 million for 2023. However, each state has its own set of guidelines regarding taxes on life insurance policies, and they vary depending on location.
There are ways to limit or avoid estate taxes on your life insurance proceeds. One way is to transfer ownership of your life insurance policy to another person or entity. This can be done by choosing a competent adult or entity as the new owner, obtaining the proper assignment or transfer of ownership forms from your insurance company, and having the new owner pay the premiums on the policy. Another way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT). By transferring ownership to an ILIT, you will no longer be considered the owner, and the proceeds will not be included as part of your estate.
It is important to note that if you die within three years of transferring ownership of your life insurance policy, the full amount of the proceeds will be included in your estate and taxed accordingly. This is known as the three-year rule. Additionally, if the cash value of the policy exceeds the gift tax exclusion, gift taxes will be assessed and will be due at the time of the original policyholder's death.
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Inheritance tax
In the United States, life insurance proceeds are generally not taxable. However, there are certain instances where the beneficiary may be taxed. One such instance is the inheritance tax, which is a tax placed on the recipient for any inherited cash payouts, properties, and other assets. Currently, Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are the only states that enforce this tax.
The inheritance tax may come into play if you live in one of the six states that enforce this measure. Each state has its own set of guidelines regarding taxes on life insurance policies. It is important to note that the inheritance tax is different from the estate tax, which is a tax on the right to transfer property upon death.
To avoid paying inheritance taxes on life insurance proceeds, it is recommended to choose your beneficiary wisely. Naming the beneficiary as ""payable to my estate" can increase the chances of being taxed. Instead, naming a person as the beneficiary may reduce the likelihood of being taxed. Consulting with a tax professional can help lower tax liability and ensure that all necessary steps are taken to avoid unnecessary taxes.
In addition to the inheritance tax, there are other instances where life insurance proceeds may be taxed. For example, if the cash value of the policy exceeds a certain threshold, the estate tax or the generation-skipping tax may apply. Additionally, if the beneficiary receives the payout as an annuity and it accrues interest, they may be taxed on that interest.
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Income tax
Life insurance proceeds are typically not considered taxable income, and beneficiaries do not need to report them. However, there are certain situations where taxes may be incurred.
Interest Income
Interest income generated from life insurance proceeds is generally taxable. This occurs when there is a delay in the payout and the money is held by the insurance company for a period, allowing interest to accumulate. In this case, the beneficiary must pay taxes on the interest earned, not on the entire benefit.
Estate Taxes
If the policyholder names their estate as the beneficiary, the death benefit may be subject to estate taxes. This can significantly reduce the amount received by loved ones. To avoid this, it is recommended to choose a person as the beneficiary instead of the estate.
Inheritance Tax
Inheritance tax is levied on the recipient of any inherited cash payouts, properties, and other assets. Currently, Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are the only states enforcing this tax.
Generation-Skipping Tax
Similar to the estate tax, the generation-skipping tax is imposed on assets that skip a generation and are only enforced when they exceed a certain threshold.
Withdrawing from Cash Value Life Insurance Policy
Withdrawing money from a cash value life insurance policy early may result in interest payments and reduced benefits over time. If the withdrawal exceeds the amount paid into the premium, it may be subject to income tax.
Selling a Life Insurance Policy
Selling a life insurance policy may trigger income and capital gains taxes if the sale amount exceeds the cost basis (the total amount of premiums paid).
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Generation-skipping tax
The GSTT was introduced in 1976 to prevent wealthy families from avoiding estate taxes at the death of each generation. Prior to this tax, it was possible to pass an unlimited amount of assets to a trust for the benefit of multiple generations, thus permanently avoiding estate taxes as each generation passed away.
The GSTT is triggered when a person gifts another person an asset but skips a generation in doing so. For example, a person could stipulate in their will that their home and other assets will go to their grandchild, skipping their child (the grandchild's parent).
The GSTT is paid by either the grantor or the skipped beneficiary, depending on how the bequest is structured. The grantor pays the direct generation-skipping tax, while an indirect generation-skipping tax is paid by the skipped beneficiary.
The GSTT has a high threshold, and most people will never encounter it. The tax only applies when the transferred amount exceeds $13.61 million per individual for 2024 and $13.99 million for 2025. This exemption amount will grow each year based on inflation through 2025 and is set to revert to around $7 million in 2026.
There are ways to reduce the GSTT, such as by contributing to 529 plans or creating dynasty trusts.
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Frequently asked questions
No, life insurance death benefits are typically tax-free, but there are exceptions.
Life insurance payouts are taxed when the beneficiary is an estate, when the payout is in installments, when the policy is surrendered, when it's an employer-paid group life insurance, or when withdrawing money from the cash value.
If the death benefit is $500,000 but it 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, you will need to transfer ownership of the policy to another person or entity.
The IRS has a tool to help determine if life insurance proceeds are taxable or nontaxable.
