Life Insurance Proceeds: How Agi Is Impacted

Life insurance is a financial product that provides financial support to your loved ones after your death. In most cases, life insurance proceeds are not taxable, but there are some exceptions. For example, if the policy was transferred 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. Additionally, if the beneficiary receives interest on the death benefit, that interest is typically taxable. It's important to understand the tax implications of life insurance to ensure that your loved ones receive the full benefit of the policy.

Interest on death benefits

Life insurance death benefits are generally not taxable. However, any interest accrued on the benefit is taxable and must be reported.

In the United States, the Internal Revenue Service (IRS) states that any interest received on life insurance proceeds is taxable and should be reported as interest received. This is also the case in New York State, where interest begins to accrue from the date of the insured's death, not the date the claim is filed.

The IRS further advises that if the 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 some exceptions to this rule, and the taxable amount should be reported based on the type of income document received, such as a Form 1099-INT or Form 1099-R.

It is always recommended to consult with a tax advisor or tax professional for specific guidance on taxation related to life insurance proceeds and interest.

Payouts to the insured's estate

If the life insurance payout is made to the insured's estate, it may be subject to taxation. This is because the payout increases the value of the estate, which could push it over the threshold for taxation. As of 2022, estates worth over $12.06 million are taxed.

The IRS considers the value of life insurance proceeds as part of the insured's gross estate if the proceeds are payable to the estate or if the insured had any incidents of ownership in the policy at the time of their death.

To avoid this, most people name individuals as beneficiaries, rather than the estate. This keeps the payout out of the estate. Another option is to set up an irrevocable life insurance trust (ILIT). In this case, the proceeds are not included as part of the estate because the insured is not considered the owner.

Policy ownership and insured are different

When it comes to life insurance, it's crucial to understand the distinct roles and responsibilities of the parties involved. While the policy owner and the insured person are often the same individual, they can also be different.

The Policy Owner

The policy owner is the person who purchases a life insurance policy and is responsible for paying the premiums. They have the right to:

• Transfer ownership
• Choose the type of policy
• Select and change beneficiaries
• Access the cash value of certain policies
• Cancel or surrender the policy
• Request policy loans
• Receive a copy of the policy and any updates

The policy owner also has the responsibility to:

• Pay premiums on time
• Keep the insurance company informed of any changes
• Keep the policy in force until death or cancellation
• Ensure the death benefit meets their needs
• Read and understand the policy terms and conditions
• Notify beneficiaries of the policy and provide necessary information for claiming the death benefit
• Inform beneficiaries of the sale of the policy to a third party

The Insured Person

The insured person is the individual whose life is insured under the contract. They have the right to be aware of all policies that list them as the insured and to not disclose health changes to the insurance carrier after the policy is purchased. The insured's main role is to provide an accurate medical history and health overview to the insurance carrier before the policy is issued.

Policy Owner and Insured Are Different

When the policy owner and the insured are different individuals, it means that someone has purchased a life insurance policy for another person. This could be a spouse insuring their partner or a business owner insuring a key employee. In these cases, the policy owner has what is known as an 'insurable interest' in the life of the insured, meaning they would suffer a financial loss if the insured were to pass away.

Taxation

It's important to note that, in the United States, life insurance proceeds are generally not included in the beneficiaries' taxable income. However, there are exceptions, such as when the policy changes ownership for cash or other valuable consideration. In such cases, the exclusion for proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts.

Surrendering a policy

Surrendering a life insurance policy means cancelling your policy and receiving a payout from your insurance company. This payout is known as the cash surrender value, which is the money a policyholder receives for ending their coverage, minus any surrender fees and taxes on earnings. Surrendering your policy is a way to get money back from it, but it also means you will lose your coverage.

The cash surrender value is different from the policy's cash value, which is the total sum in the savings component of permanent policies. The cash surrender value is lower because of surrender fees, which are usually between 10-35% and are highest in the early years of the policy. Most policies also have a waiting period of at least 15 years before you have the option to surrender them.

When you surrender your policy, you will lose coverage and will no longer be responsible for paying insurance premiums. You may have to pay surrender fees for cancelling your coverage early, which will be deducted from any cash value your policy has or paid out of pocket if you have a term policy. You may also have to pay taxes on the surrender value if earnings exceed the amount you've paid into the policy.

For example, if you've paid $20,000 into a policy through premiums but have a cash value of $30,000, you will need to pay taxes on the $10,000 in earnings over what was paid in. The amount of taxes you'll pay depends on your income bracket. Assuming a rate of 22%, that would be $2,200, leaving you with a cash surrender value of $27,200 before fees. If surrender fees are 20%, that would be another $5,440, leaving a final cash surrender value of $21,760.

There are several reasons why someone might surrender a policy, including no longer needing coverage, the cost of premiums, finding a better policy, and needing cash. However, it's important to consider the pros and cons of surrendering a policy, as it's a life-changing decision that will affect you and your family.

Policy loans

As you pay the premiums on a permanent life insurance policy, a portion of the payments goes toward the policy's cash value. The cash value of a life insurance policy accrues interest and grows tax-free. After the cash value reaches a certain amount, you can take out a loan against the life insurance policy, known as a policy loan. It often takes years of paying premiums before life insurance policies have enough cash value to borrow against.

You'll need to fill out a form with your insurance provider to take out a policy loan. Because the cash value of your insurance policy serves as collateral for the loan, the insurance provider will not need to run a credit check, so the process is quick, and you will often have the money within days.

When you take a policy loan, the money doesn't actually come out of your policy. Instead, it comes from the insurance company's general pool of funds, and your policy's cash value is used as collateral. The money in your policy continues to earn interest, but you will also be charged interest on the loan you take out. You won't need to pay taxes on the money you borrow as long as your policy remains active.

There is no repayment schedule for a policy loan, so you can pay back the principal and the accumulated interest however you'd like. If you don't pay the annual interest payments on the loan, the cost of the interest payments will be taken out of your policy.

If the interest on your loan accumulates to the point that the amount of the loan plus interest is greater than the cash value of the policy, the policy will lapse, and you will lose your life insurance coverage. At this point, you will probably have to pay taxes on the loan as it will be treated as income rather than a loan. Once your policy lapses, you will no longer have life insurance coverage in case of death.

Insurers' requirements for taking a policy loan vary by insurance provider. With most policies, you will need to pay premiums for several years before you can take out a policy loan.

If you don't make the annual interest payments on your loan, the interest will be paid using the remaining cash value of the policy as well as the death benefit. Over time, the death benefit will continue to decrease. If the policy lapses, you'll likely owe income taxes on the loan, and your loved ones won't get any financial payout when you die.

Frequently asked questions