Life Insurance And Taxes: What's The Deal?

Life insurance is a valuable tool for financial planning, as it ensures your loved ones will receive a payout in the event of your death. But do these beneficiaries have to pay taxes on this money?

In most cases, life insurance proceeds are not taxable, so your beneficiaries will receive the full amount. However, there are some exceptions. For example, if the payout is made in installments, any interest accrued will be taxable. If the policyholder names their estate as the beneficiary, taxes may also be due, depending on the estate's value.

Interest accrued on the policy

Life insurance is one of the few types of insurance that can gain value over time. However, not all types of life insurance accrue interest, and the amount of interest that can be gained is limited by the terms of the contract. Term life insurance, for example, does not accrue interest. Permanent life insurance, on the other hand, usually does earn interest, with the exception of final expense insurance. Whole and universal life insurance, and their variations, almost always accrue interest over time.

The interest that accrues from a life insurance policy payout is typically subject to federal income tax. This is the case whether the beneficiary receives the proceeds as a lump sum or in periodic payments. The interest is calculated from the date of the death of the insured to the date of payment, and not from the date that the claim is filed. This interest is taxable to the beneficiary, while the unearned premium is not, because the insured paid using after-tax dollars.

When a beneficiary elects to receive periodic payments over a number of years, rather than a lump sum, the insurance company usually pays interest on the remaining balance. The tax code treats these types of payments similarly to annuities because the payout and tax-exempt amounts are known upfront. For example, a $250,000 policy may pay out $2,200 per month for 10 years, totalling $264,000. Each payment consists of the death benefit and interest, with $110 of the $2,200 monthly payment being taxable interest.

If the beneficiary chooses to keep the payout on deposit, the insurance company will report how much interest was earned on a Form 1099 each year. The beneficiary must report the interest as income in the year it is earned, even if they leave it on deposit with the company.

Policyholder names the estate as a beneficiary

When a policyholder names their estate as a beneficiary, the death benefit paid to the estate is typically taxable. This is because the death benefit is included in the value of the estate for estate tax purposes. In 2024, estates over $13.61 million are subject to estate tax.

If the policyholder names their estate as the beneficiary, they lose the contractual advantage of naming a real person as the beneficiary. This also subjects the financial product to the probate process. Leaving items to your estate also increases the estate's value, which could result in exceptionally high estate taxes for your heirs.

To avoid this, the policyholder can transfer ownership of the policy to another person or entity. This involves choosing a competent adult or entity as the new owner, which can be the policy beneficiary. The new owner must pay the premiums on the policy. The previous owner can gift up to $16,000 per person in 2022 or $17,000 in 2023 to help cover the cost of premiums. The previous owner will give up all rights to make changes to the policy in the future. However, if the new owner is a child, family member, or friend, changes can be requested by the previous owner and made by the new owner. It is important to obtain written confirmation from the insurance company as proof of the ownership change.

Another option is to create an irrevocable life insurance trust (ILIT). The policy is held in trust, and the proceeds are not included as part of the estate. The original owner cannot be the trustee of the trust and must not retain any rights to revoke the trust.

Insured and policy owner are different individuals

When it comes to life insurance and taxes, the general rule is that life insurance proceeds received by a beneficiary due to the death of the insured person are not included in gross income and do not need to be reported as taxable income. However, there are some important exceptions and special cases to consider, especially when the insured and the policy owner are different individuals.

In most cases, the person who purchases a life insurance policy is considered both the owner and the insured. However, if these roles are held by different people, there may be tax implications. When the insured and the policy owner are not the same individual, the IRS may conclude that the death benefit amount from the policy owner to the beneficiary is a gift, and gift tax may be owed. This is because, in most cases, the insured and the policy owner are typically the same person.

It is important to note that gift tax only comes into play if the total amount of gifts made exceeds the annual gift tax exclusion. For 2023, the annual gift tax exclusion is $17,000 per person. So, if the death benefit amount is more than this exclusion, the beneficiary may have to pay gift tax on the amount received.

To avoid potential gift tax consequences, one strategy is to transfer ownership of the life insurance policy to another person or entity. This can help ensure that the proceeds are not included in the taxable estate of the original policy owner. It is important to obtain proper forms from the insurance company and follow all necessary procedures for a valid ownership transfer. Keep in mind that the new owner will be responsible for paying the premiums, and the original owner will give up the rights to make changes to the policy.

Another option to consider is setting up an irrevocable life insurance trust (ILIT). In this case, the trust owns the life insurance policy, and the proceeds are not included in the estate of the original policy owner. This option can be beneficial if you want to maintain some legal control over the policy or ensure that premiums are paid promptly. However, it is important to note that you cannot be the trustee of the trust and must give up any rights to revoke it.

Policy loans

If a policy loan is outstanding when the policyholder dies, the beneficiary will receive a lower death benefit, but this reduced benefit will likely not be taxed.

It is important to note that the presence of a policy loan can distort outcomes if/when a life insurance policy is surrendered or lapses. In such cases, the insurance company will require that the loan be repaid from the proceeds of the policy. If the loan exceeds the cash value, the policy may lapse, and the policyholder may be left with a tax bill larger than the remaining cash value.

To avoid this "tax bomb," it is crucial to monitor the loan balance and ensure the policy remains active. Keeping the policy until the death of the insured allows the loan to be repaid from the tax-free death benefit.

Estate taxes

Life insurance payouts are generally not subject to income taxes or estate taxes. However, there are certain exceptions. The type of policy you have, the size of your estate, and how the benefit is paid out can determine if life insurance proceeds are taxed.

If a life insurance policy has no named beneficiaries, the proceeds may be included in the deceased's estate. If the value of the estate exceeds the federal estate tax threshold, estate taxes must be paid on the amount that is over the limit. The federal estate tax threshold was $13.61 million as of 2024. However, this figure may change annually. For example, it was $12.92 million in 2023 and $12.06 million in 2022. Some states also assess inheritance or estate taxes, depending on the estate's value and where the deceased lived.

To avoid estate taxes, you can transfer ownership of your life insurance policy to another person or entity. This must be done at least three years before your death, as the IRS has a three-year rule that subjects gifts of life insurance policies made within three years of death to federal estate tax. You can also create an irrevocable life insurance trust (ILIT) to hold the policy, which will remove the proceeds from your taxable estate.

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