Life Insurance: A Valid Income Source?

Life insurance is a contract under which an insurance company agrees to pay a specified amount after the death of an insured party, as long as the premiums are paid. The payout amount is called a death benefit. In most cases, life insurance proceeds are not considered taxable income. However, there are some exceptions to be aware of. For example, if your loved ones choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. That extra money from interest is considered taxable income, even though the original death benefit is not. Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate’s total value is large enough, it may trigger estate taxes, reducing what your loved ones ultimately receive.

Taxation on life insurance interest

• Beneficiary Taxation: Generally, life insurance proceeds received by a beneficiary due to the insured person's death are not considered taxable income and don't need to be reported. However, any interest accrued on the proceeds is taxable. The beneficiary must pay taxes on this interest, which is reported to the Internal Revenue Service (IRS) by the insurance company.
• Transfers and Considerations: If the life insurance policy was transferred to the beneficiary for cash or other valuable considerations, the exclusion for proceeds is limited. The taxable amount, in this case, is based on the type of income document received, such as Form 1099-INT or Form 1099-R.
• Interest Accumulation: When a beneficiary receives life insurance proceeds after a period of interest accumulation rather than immediately, they must pay taxes on the interest. For example, if a $500,000 death benefit earns 10% interest for a year before payout, the beneficiary owes taxes on the $50,000 growth.
• Estate and Inheritance Taxes: Naming an estate as the beneficiary instead of an individual can have tax implications. The inherited money from the life insurance policy is typically not taxed as income. However, if the policyholder named an estate as the beneficiary, the value of the life insurance proceeds is included in the estate's gross value, potentially subjecting heirs to high estate taxes.
• Modified Endowment Contracts (MECs): MECs are life insurance policies that are classified differently for tax purposes due to the total premium paid exceeding a certain limit. In MECs, distributions are taxed as earnings first, followed by a return of the policy's cost basis. Withdrawals, surrenders, loans, and collateral assignments are treated as distributions and are taxable to the extent of gain.
• Policy Loans: Interest charged on outstanding policy loans is generally not tax-deductible. If the policy lapses with an outstanding loan, the total policy debt (including loans and unpaid accrued interest) may result in taxable income if it exceeds the cost basis.
• Surrendering a Policy: Surrendering a life insurance policy may result in taxable income if the gross surrender proceeds (including cash received, policy loans, and accrued interest) exceed the cost basis.
• Dividends and Interest: While dividends received on participating whole life insurance policies are typically not taxed, any interest earned on those dividends is considered taxable income and must be reported.
• Business-Owned Policies: Interest paid on loans from business-owned life insurance contracts may be tax-deductible, but with significant restrictions. The deduction is limited to policies covering the lives of key persons, such as officers or 20% owners of the business.
• Avoidance Strategies: To avoid taxation on life insurance proceeds, individuals can consider strategies such as choosing a lump-sum payout, using an irrevocable life insurance trust (ILIT), transferring ownership early, and regularly reviewing and updating beneficiaries.

Taxation on life insurance premiums

Taxation for Beneficiaries

In general, if you are the beneficiary of a life insurance policy, the payout you receive is not considered part of your gross income and is therefore not subject to income or estate taxes. This applies to term, whole, and universal life insurance policies. However, any interest accrued on the payout is taxable and must be reported. Additionally, if the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds may be limited, and you may need to report the taxable amount.

Taxation on Death Benefits

Death benefits from life insurance policies are typically paid to the named beneficiary or beneficiaries tax-free. However, there are certain situations where the death benefit can be taxed. For example, if the payout is structured as multiple payments over time, such as an annuity, the payments may be subject to taxes. If the policyholder has withdrawn money or taken out a loan against the policy, and the amount withdrawn exceeds the total amount of premiums paid, the excess may be taxable.

Employer-Paid Group Life Plans

In some cases, employer-paid group life plans that pay out more than $50,000 may be taxable, according to the Internal Revenue Service (IRS). This is considered a taxable fringe benefit. However, if the death benefit is paid to beneficiaries, it is typically tax-free.

Estate Taxes

If life insurance proceeds are included as part of the deceased's estate, and the total value exceeds the federal estate tax threshold (which was $12.92 million as of 2023), estate taxes must be paid on the proceeds over the allowed limit.

Policy Surrender

If you surrender a life insurance policy, the amount you receive is typically considered a tax-free return of your principal. However, any funds you receive over your policy's cash basis will be taxed as regular income.

Premium Deductions

Life insurance premiums are generally not tax-deductible, even for business owners. This applies regardless of whether the business is a beneficiary of the policy.

Modified Endowment Contracts (MECs)

If the total amount of premium paid into a policy exceeds a certain limit, it may be classified as a Modified Endowment Contract (MEC). MECs receive less favourable tax treatment than non-MEC policies. Distributions from a MEC are generally taxed as earnings, followed by a return of the policy's cost basis.

Life insurance and estate tax

Life insurance proceeds are generally not considered part of the beneficiary's gross income and are not subject to income or estate taxes. However, there are certain situations where life insurance benefits may be subject to estate tax.

According to the Internal Revenue Service (IRS), if the death benefit and the total value of the deceased's estate exceed the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. This threshold was $12.92 million as of 2023 and is expected to drop to approximately $6 million in 2026. Therefore, careful estate planning is essential to minimize or eliminate estate tax liability.

To avoid estate tax on life insurance proceeds, it is crucial to prevent two conditions:

• Payment to the insured's estate: Ensure that the estate is not designated as the beneficiary of the life insurance policy.
• "Incidents of ownership": The insured should not retain any economic ownership rights in the policy. This includes rights such as the ability to change beneficiaries, assign or revoke the policy, pledge the policy as collateral, borrow against the policy's cash value, or surrender or cancel the policy.

There are several strategies to avoid estate tax on life insurance proceeds:

• Buy-sell agreements: Life insurance obtained to fund a buy-sell agreement for a business interest under a "cross-purchase" arrangement will generally not be taxed in the insured's estate unless the estate is named as the beneficiary.
• Irrevocable life insurance trusts (ILITs): Transferring the policy to an ILIT along with assets to pay future premiums can keep the proceeds from being taxed in the insured's estate.
• Three-year rule: If you transfer ownership rights or set up a life insurance trust, the insured must survive for at least three years after these steps are taken to avoid the proceeds being taxed in their estate.
• Alternative ownership: Using irrevocable trusts, limited partnerships, limited liability companies, or direct ownership by children can help taxpayers reduce estate tax liability.

Life insurance and gift tax

Life insurance proceeds are generally not taxable as gross income for the beneficiary. However, if you give a permanent life insurance policy to another person, including a beneficiary, the IRS treats the transaction as a gift, which may be taxed depending on the policy's worth.

The gift tax applies if you transfer a policy with a fair market value above the annual gift tax exclusion, which is $18,000 in 2024. The gift tax is only payable upon your death and only if your estate exceeds the federal gift and estate tax exemption, which is $13.61 million for individuals and $27.22 million for married couples in 2024.

For example, if you transfer a policy worth $28,000, the amount above the $18,000 exclusion, which is $10,000, will be subject to gift tax.

It's important to note that term life insurance policies, which don't have a cash value, are not subject to gift tax but may trigger an estate tax.

Life insurance and income tax

Life insurance is often seen as a way to provide for loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs or securing their future. However, there are some exceptions and special cases to be aware of.

Taxation of Life Insurance Proceeds

In most cases, life insurance proceeds are not considered taxable income. When a beneficiary receives a death benefit, this money is generally not counted as taxable gross income. However, there are certain situations where the beneficiary may be taxed on some or all of a policy's proceeds.

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 time. This interest is considered taxable income, even though the original death benefit is not.

According to the IRS, if the life insurance policy was transferred to the beneficiary for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. There are exceptions to this rule, and generally, the taxable amount is reported based on the type of income document received, such as a Form 1099-INT or Form 1099-R.

Taxation of Life Insurance Premiums

Life insurance premiums are typically not tax-deductible for personal policies. However, there are a few exceptions. If you gift a life insurance policy to a charity and continue to pay the premiums, those payments are generally considered charitable donations and may be tax-deductible.

Additionally, if you own a business and provide life insurance for your employees, the premiums you pay may be tax-deductible as a business expense. It's important to consult with a tax professional to understand your specific situation and maximize any potential tax benefits while staying compliant with the law.

Strategies to Avoid Life Insurance Taxes

While life insurance policies offer many tax advantages, careful planning is necessary to mitigate potential tax liabilities. Here are some strategies to help avoid or minimize these tax implications:

• Choose a lump-sum payout: Opting for a lump-sum payout keeps the death benefit income tax-free and helps avoid taxable interest on installment payments.
• Avoid the Goodman Triangle: In this scenario, three different individuals are involved in a life insurance policy, which can trigger a gift tax. To prevent this, financial advisors suggest having only two parties involved, with the insured and owner or the owner and beneficiary being the same person.
• Use an irrevocable life insurance trust (ILIT): By transferring the policy to an ILIT, you can keep the death benefit out of your taxable estate if certain rules are met. Ensure the transfer occurs at least three years before death.
• Keep policy loans in check: Monitor your loan balance and ensure the policy remains active to prevent taxable income from policy loans.
• Transfer ownership early: Transferring policy ownership well in advance (more than three years before death) helps keep the policy out of your taxable estate.
• Regularly review beneficiaries: Ensure your estate isn't named as the beneficiary to prevent estate taxes. Update beneficiary designations as life changes occur.

Frequently asked questions