Life Insurance And Taxes: What You Need To Know

Life insurance payouts are generally not subject to income or estate taxes, but there are certain exceptions. The type of policy, the size of the estate, and the method of payment can determine whether or not life insurance proceeds are taxable. For example, if the payout is set up to be paid in multiple instalments, the payments can be taxable. Similarly, if the policyholder has withdrawn money or taken out a loan, and the amount withdrawn or loaned exceeds the total amount of premiums paid, the excess may be taxable. It is important to consult a tax advisor about your unique situation to understand the tax implications of your life insurance policy.

Lump-sum payouts are generally tax-free

Life insurance is often seen as a reliable way to provide for your loved ones after you pass away. 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 to this. If the payout is structured as an annuity, or multiple payments, the payments can be taxable. This is because the payments include both proceeds and interest, and the interest is considered taxable income. Similarly, if the policyholder has withdrawn money or taken out a loan against the policy, and the amount withdrawn or loaned exceeds the total amount of premiums paid, then the excess may be subject to income taxes.

In the case of an employer-paid group life plan, if the payout exceeds $50,000, it may be taxable according to the Internal Revenue Service (IRS). Additionally, if the death benefit and the total value of the deceased's estate exceed certain limits, estate taxes must be paid on the proceeds over the allowed limit. As of 2023, the federal estate tax threshold was $12.92 million.

While lump-sum payouts are generally tax-free, it's important to be aware of these exceptions and consult with a tax professional to understand the specific tax implications for your situation.

Interest accrued on payouts may be taxable

Life insurance payouts are generally not taxable. However, there are certain exceptions, and one of them is the accrual of interest on the payouts.

If the beneficiary of a life insurance policy receives a lump-sum payout, it is typically not considered part of their gross income, and they don't have to pay income or estate taxes on it. However, if the beneficiary chooses to receive the payout in instalments, any interest accrued during the period before the payout may be subject to federal income tax. This is because the interest is considered taxable income. The tax code treats these instalment payments similarly to annuities.

For example, if a beneficiary chooses to receive $10,000 as a lump sum and $700 in monthly payments for 10 years, they will have to pay taxes on the interest earned on the $700 monthly payments. In this case, 5% of each monthly payment, or $35, would be considered taxable interest.

If the beneficiary decides to leave the payout on deposit with the insurance company, earning interest, they must still report the interest as income in the year it is earned, even if they don't withdraw it.

It is important to note that the rules and regulations regarding life insurance and taxes may vary based on location and specific circumstances. Therefore, it is always advisable to consult with a tax professional or financial advisor for personalised guidance.

Withdrawing or taking out a loan against a whole life policy

When you take out a loan against your whole life policy, the money does not actually come directly from your policy. Instead, the insurance company lends you the money and uses your policy as collateral. This means that the policy's cash value can continue to accumulate, but it's important to understand how interest and dividends will be determined and paid. Interest is added to the loan, and if it is not paid, your policy could lapse. Therefore, it is important to pay the loan back in a timely manner, on top of your regular premium payments. If the loan is not repaid before the policyholder's death, the loan amount and any interest owed will be deducted from the death benefit paid to the beneficiaries.

In terms of taxes, the loan is not recognised by the IRS as income and is therefore not taxable, as long as it does not exceed the amount paid in premiums for the policy and the policy remains in effect. However, if you withdraw more than your cumulative premium payments, you may have to pay income taxes on the excess. Similarly, if you borrow against the cash value and the loan is still outstanding when the policy is terminated or surrendered, the loan amount in excess of the cumulative premiums may be subject to income taxes.

Surrendering your life insurance policy

The cash surrender value of a life insurance plan is the amount you receive if you surrender your policy to your insurer. It is based on the cash value of the policy, which is the component of a permanent life insurance policy that helps you build cash value through regular premium payments. The cash surrender value can depend on the policy's duration, growth, and assets. Surrendering your policy earlier in the term may result in a lower cash surrender value since the cash value will be smaller, and you may owe surrender charges. However, if you surrender the policy later, you could receive a larger payout as the cash value will be larger, and you'll pay fewer fees.

Some companies may charge a surrender fee to complete this transaction. If the surrender proceeds exceed the cumulative premiums, the excess may be subject to income taxes. However, if the surrender value is less than the cumulative premiums paid for the policy, you likely won't pay income taxes on the cash payment you receive from the insurer.

If you want to surrender your policy and receive the cash surrender value, you should first review your life insurance policy documents and inform your life insurance provider. They will guide you through the process of surrendering the policy and paying the cash surrender value. You will then need to fill out the necessary paperwork and receive the cash surrender value from your insurer. It is important to consult with a tax expert and financial advisor, as receiving a large payout could trigger tax consequences.

Employer-paid group life insurance

If your employer provides life insurance, it is likely considered a fringe benefit. While desirable, there can be tax implications if the coverage is higher than $50,000. The first $50,000 of group term life insurance coverage that your employer provides is excluded from taxable income and won't add anything to your income tax bill. However, the cost of coverage above $50,000 is considered taxable income for you. This is based on the IRS Premium Table, not the actual cost, and is subject to social security and Medicare taxes.

This taxable income is included in the wages reported on your Form W-2, even though you never physically receive it. This is often referred to as "phantom income". The amount of this phantom income attributed to an older employee is often higher than the premium the employee would pay for comparable coverage under an individual term policy. This becomes a bigger issue as an employee gets older and their compensation increases.

If you feel that the tax cost of employer-provided group term life insurance is too high for the benefit, you can look into whether your employer has a "carve-out" plan. With this type of plan, the employer can continue to provide $50,000 of group term insurance (as there's no tax cost for the first $50,000 of coverage) and then provide an individual policy for any additional coverage. Alternatively, the employer can give you a cash bonus to cover the excess coverage, which you can then use to pay the premiums on an individual policy.

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