Life Insurance Payouts: Are They Taxable?

Life insurance is often taken out to provide peace of mind and financial security for loved ones after the policyholder's death. The death benefit paid out to beneficiaries is typically tax-free, but there are some exceptions and complications to be aware of. For example, if the payout is made in installments, any interest accrued may be taxable. Similarly, if the payout is made to the estate rather than directly to a person, it could be subject to estate taxes. There are also tax implications if the policyholder and insured are different people, and if the policy is surrendered or cancelled. Understanding the tax liability of life insurance payouts is essential for beneficiaries and policyholders alike, especially when dealing with large sums of money.

Interest on installments

While life insurance proceeds are usually not taxable, the interest on life insurance instalments is taxable. This is because the interest is considered taxable income.

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

Therefore, if the beneficiary of a life insurance policy chooses to receive the payout in instalments, they will have to pay taxes on the interest that accumulates on those payments. This can result in a higher tax burden than if they had chosen to receive the payout as a lump sum.

To avoid this, beneficiaries can choose to receive the life insurance payout as a lump sum, which is typically not taxed. They should also be sure to regularly review the policy and keep their information up to date to avoid any tax complications.

Estate taxes

Life insurance is often tax-free, but there are some situations where estate taxes may be triggered.

If the policyholder names their estate as the beneficiary, the person or people inheriting the estate may have to pay estate taxes. This is because the estate's value increases, and it could subject heirs to exceptionally high estate taxes. This is one of the most common mistakes investors make.

The estate's value may be pushed above the federal estate tax exemption, which was $13.61 million in 2024, triggering these estate taxes. While this generally only applies to high-net-worth individuals, some states have a lower threshold for state estate tax, so it is important to factor this into your planning. Working with an estate planner can help minimise tax implications and ensure your loved ones receive as much of the death benefit as possible.

To avoid estate taxes, you can transfer ownership of your policy to another person or entity. This must be done at least three years before death, and the new owner must pay the premiums.

Policy ownership

Ownership and Taxation

The owner of a life insurance policy can be different from the insured person. While the insured is the one whose life is covered by the policy, the owner is the person or entity that purchases and maintains the policy. The owner has the right to make changes to the policy, such as updating beneficiaries or adjusting coverage levels. It is important to note that the IRS has specific rules to determine the ownership of a life insurance policy, especially when it comes to taxation.

Transfer of Ownership

Transferring ownership of a life insurance policy can have tax implications. If the policy is transferred to another person or entity, the new owner becomes responsible for paying the premiums. It is essential to choose a competent adult or entity as the new owner, and they should be able to manage the policy effectively. The original owner must give up their rights to make changes and cannot pay the premiums. By transferring ownership, the policy can be removed from the original owner's taxable estate, potentially reducing their tax burden.

Three-Year Rule

According to the IRS's three-year rule, any gifts of life insurance policies made within three years of the insured's death are still subject to federal estate tax. This means that if the insured person dies within three years of transferring ownership, the proceeds will be included in their estate for tax purposes. This rule encourages individuals to plan ahead and make timely decisions regarding their life insurance policies.

Incidents of Ownership

Even after transferring ownership, the IRS will consider any "incidents of ownership" by the previous owner. This includes actions such as changing beneficiaries, borrowing against the policy, or cancelling the policy. If the previous owner retains these rights, it could negate the tax advantages of transferring ownership. Therefore, a complete transfer of ownership is necessary to avoid unexpected tax consequences.

Gift Tax Considerations

When transferring ownership, it is important to consider the gift tax exclusion. If the current cash value of the policy exceeds the annual gift tax exclusion ($17,000 in 2023), gift taxes may be assessed and due at the time of the original policyholder's death. This is an important consideration, especially for policies with significant cash values.

Irrevocable Life Insurance Trusts (ILITs)

Another strategy to manage policy ownership and taxation is to establish an ILIT (Irrevocable Life Insurance Trust). By transferring the policy to an ILIT, the owner can remove it from their taxable estate. However, they must give up all rights to the policy and cannot act as the trustee. ILITs offer the advantage of maintaining some legal control over the policy and ensuring prompt payment of premiums. They are particularly useful when the beneficiaries are minor children, as a trusted family member can be named as the trustee.

In conclusion, policy ownership has a significant impact on the tax implications of life insurance proceeds. By understanding the rules and regulations regarding ownership transfers, individuals can make informed decisions to minimise their tax burden and ensure their beneficiaries receive the maximum benefit from the policy. Proper planning and timely action are crucial to navigate the complex world of life insurance taxation successfully.

Withdrawing money from cash value

Withdrawing money from the cash value of a life insurance policy is a complex process with many factors to consider. Here is a detailed guide to help you understand the key aspects:

Understanding Cash Value in Life Insurance

Cash value is a feature of permanent life insurance policies, which includes whole life and universal life insurance. This value accumulates over time and can be used to supplement income during retirement, cover expenses, or make large purchases. It is important to note that term life insurance policies do not build cash value.

Methods of Withdrawing Money

There are a few ways to access the cash value of a life insurance policy:

• Withdrawal: You can withdraw cash from your permanent life insurance policy, often without paying income taxes as long as the withdrawal does not exceed the amount you have paid into the policy. However, this may reduce your death benefit, and there could be early withdrawal fees for newer policies.
• Loan: You can borrow money through your policy, with the insurer using your policy as collateral. These loans typically have lower interest rates compared to personal or home equity loans, and there is no loan application or credit check required. However, any unpaid loan balance will reduce your benefits.
• Surrender: You can cancel your policy and receive the surrender value in cash, either as a lump sum or over time. However, this option comes with surrender fees and results in the loss of life insurance coverage, meaning your beneficiaries will not receive a death benefit.
• Sell: You may be able to sell your policy to a life settlement company, receiving a lump sum payment. However, your heirs will not receive a death benefit, and you may owe taxes on the sale.

Factors to Consider

When considering withdrawing money from the cash value of your life insurance policy, it is important to weigh the following factors:

• Tax Implications: Withdrawals up to the amount you have paid into the policy are generally not subject to income taxes. However, if you withdraw more than this amount, you may owe income tax on any earnings. Additionally, if your policy is a modified endowment contract (MEC), withdrawals may be treated as taxable income.
• Impact on Death Benefit: Withdrawing money from your cash value will likely result in a reduction in your death benefit. This reduction may be greater than the amount withdrawn, depending on the specific terms of your policy.
• Fees and Penalties: Surrendering your policy may incur significant surrender fees, especially for newer policies. Additionally, there may be early withdrawal fees for newer policies, and you could face penalties if your policy lapses due to insufficient funds.
• Timing: It typically takes a few years for the cash value in a policy to grow to a usable sum. Withdrawing money too early may result in fees and penalties, and it could put your policy at risk.
• Alternative Options: Before withdrawing from your cash value, consider alternative options such as taking a loan against the policy, using the cash value to pay premiums, or exploring other sources of funding like personal loans or home equity loans.

In conclusion, withdrawing money from the cash value of a life insurance policy can provide financial flexibility, but it is important to carefully consider the potential impacts on your death benefit, taxes, and fees. Be sure to review the specific terms of your policy and consult a financial advisor to make an informed decision.

Surrendering the policy

Surrendering your life insurance policy means you are cancelling the policy. Instead of your beneficiaries receiving the death benefit, you will receive the cash value that your policy has built up over time. This can be a good option if you no longer need the coverage, but it can also cause you to lose out on a significant amount of return on your investment in the policy.

There are a few things to keep in mind when considering surrendering your life insurance policy. Firstly, if your policy isn't very old, you may incur surrender fees that will reduce the amount of cash you receive. Secondly, the gain on your policy will be taxed as income. Death benefits are tax-exempt, but the cash you receive from surrendering the policy is taxable.

To illustrate with an example, let's say you've paid $20,000 in premiums over the time you held the policy, and the cash value of the policy is $30,000. In this case, you will need to pay taxes on the $10,000 in earnings over what you paid in. The amount of tax you'll pay depends on your income bracket. For example, if your tax rate is 22%, you would pay $2,200 in taxes. This would bring your cash surrender value to $27,200 before fees. Assuming surrender fees are 20%, you would be left with a final cash surrender value of $21,760.

It's important to carefully consider all the implications before surrendering your life insurance policy. While it can provide a quick source of cash, it may not be the best option for your financial future.

Frequently asked questions