Life Insurance Payouts: Are They Taxed In Virginia?

Life insurance is often seen as a reliable way to provide for loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. In most cases, life insurance proceeds are not taxable, but there are some exceptions. For example, if your loved ones choose to receive the life insurance payout in instalments instead of a lump sum, any interest that builds up on those payments could be taxed. Additionally, if a policy is owned by an irrevocable trust, the trust is responsible for any tax owed, though the proceeds would not become part of the insured's estate if the insured had no incidents of ownership.

Virginia's death benefit subtraction

In Virginia, a death benefit subtraction refers to a provision in the state's tax code that allows a taxpayer to subtract death benefit payments from their taxable income. To qualify for this subtraction, the death benefit payment must meet three requirements:

• The source of the payment must be an annuity contract between a customer and an insurance company.
• The payment must be awarded to the beneficiary in a lump sum.
• The payment must be subject to federal income taxation.

This provision was created to equalize the tax treatment of death benefits for those who cannot obtain life insurance due to health reasons and must, therefore, utilize annuities to provide similar benefits to their loved ones. It is important to note that the death benefit subtraction was not intended to be permitted for payments from a retirement plan.

Life insurance and federal taxation

Life insurance proceeds are generally not taxable at the federal level. If you are the beneficiary of a life insurance policy, you do not have to include the payout you receive in your gross income and you do not have to report it. However, any interest you receive on the payout is taxable and must be reported.

If the policy was transferred to you for cash or other valuable consideration, the exclusion for the payout is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts. There are some exceptions to this rule. Generally, you report the taxable amount based on the type of income document you receive, such as a Form 1099-INT or Form 1099-R.

Life insurance proceeds may still be included as part of your taxable estate for estate tax purposes. Section 2042 of the Internal Revenue Code states that the value of life insurance proceeds insuring your life is included in your gross estate if the proceeds are payable: 1) to your estate, either directly or indirectly, or 2) to named beneficiaries if you possessed any incidents of ownership in the policy at the time of your death.

The Tax Cuts and Jobs Act (TCJA) of 2017 determined the exemption amount at above $12.06 million for 2022 ($12.92 million for 2023), while maintaining the top rate of 40%. Note that not all estates are subject to taxes.

To avoid federal taxation on life insurance proceeds, you can transfer ownership of your policy to another person or entity. Here are some guidelines to keep in mind:

• Choose a competent adult or entity to be the new owner (it can be the policy beneficiary), then obtain the proper assignment or transfer of ownership forms from your insurance company.
• New owners must pay the policy premiums. However, you can gift up to $16,000 per person in 2022 ($17,000 for 2023), so the recipient could use some of this gift to pay premiums.
• You will give up all rights to make changes to the policy in the future. However, if a child, family member, or friend is named the new owner, they can make changes at your request.
• Obtain written confirmation from your insurance company as proof of the ownership change.

Another way to avoid taxation is to create an irrevocable life insurance trust (ILIT). You cannot be the trustee of the trust and you may not retain any rights to revoke it. In this case, the policy is held in trust, and you are no longer considered the owner, so the payout is not included as part of your estate.

Virginia's tax on retirement plans

Virginia has relatively low retirement taxes. Social Security retirement benefits are not taxed in Virginia. However, other types of retirement income, such as pension income and retirement account withdrawals, are deductible up to $12,000 for seniors.

With a few exceptions, if a source of income is taxable at the federal level, it is also taxable at the state level in Virginia. This includes most sources of retirement income, including 401(k)s, 403(b)s, and similar investments, Tier 2 Railroad Retirement, and Individual Retirement Accounts (IRAs).

Virginia does not tax Social Security benefits. If any portion of your Social Security benefits is taxed at the federal level, you can subtract that amount on your Virginia return. This also applies to Tier 1 Railroad Retirement. Virginia also offers qualifying individuals aged 65 and older a subtraction that reduces the amount of their income subject to Virginia income tax. If you were born on or before January 1, 1939, you can subtract $12,000. If you were born after this date, the amount of the allowed subtraction is based on your income.

A traditional IRA usually allows you to deduct the amount you contributed to the account from your federal taxes, so your distributions are usually taxable. With a Roth IRA, you pay taxes on the money you add to your account when you earn it, so you usually don't pay tax on your distributions.

Virginia residents are subject to tax on their entire incomes, including federal annuities and military pensions. To the extent that these payments are reported in federal adjusted gross income, they are also subject to Virginia income tax.

Life insurance and estate tax

In Virginia, life insurance benefit payments paid due to the death of the insured are exempt from federal taxation and, therefore, exempt from Virginia taxation. However, a portion of the death benefits from an annuity, including life insurance contracts, are taxable.

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 some cases when a death benefit can be taxed. For example, if the payout is set up to be paid in multiple payments, the payments can be taxable. If the policyholder has withdrawn money or taken out a loan, and the money withdrawn or loaned is more than the total amount of the premiums paid, the excess may be taxable.

In the context of estate planning, it is important to consider the potential tax implications of life insurance proceeds. According to the Internal Revenue Code, life insurance proceeds are taxable in the estate of the insured if the proceeds are paid to the insured's estate or if the insured retained any "incidents of ownership" in the policy. Outright ownership is an "incident of ownership," but certain rights less significant than ownership can also result in estate taxation, such as the right to change the beneficiary or borrow against the policy to pay premiums.

To prevent estate tax on life insurance proceeds, it is necessary to avoid payment to the insured's estate and incidents of ownership. This can be achieved by having another person or entity apply for and purchase a new policy on the insured's life or transferring all incidents of ownership in an existing policy to another person or entity. Additionally, the three-year rule states that if the insured passes away within three years of transferring ownership of the policy, the proceeds will be taxed in their estate.

Life insurance and inheritance tax

Life insurance payouts are generally exempt from federal taxation and, therefore, exempt from Virginia taxation. However, it's important to note that Virginia does impose a probate tax on estates, which includes certain types of property within an estate. While insurance proceeds payable to a named beneficiary (other than the estate) are exempt from probate tax, life insurance policies are included in the calculation of the gross taxable estate for estate tax purposes.

In Virginia, there is no longer an independent estate tax or inheritance tax. However, this does not mean that residents should disregard estate tax entirely, as there may still be federal estate tax liability. The federal estate tax exemption is $5,450,000 for decedents dying in 2016, and the tax is due nine months from the decedent's date of death. Virginia does not require an estate tax return unless there is a federal estate tax return due.

When reviewing whether an estate tax return is necessary, any assets in the decedent's control at the time of death are includable, such as real estate holdings, bank accounts, investments, personal property, and life insurance policies. It's important to understand that assets owned jointly or beneficiary-driven assets are still includable in the calculation of the gross taxable estate.

Additionally, when someone passes away, there are typically three taxing systems to consider: inheritance tax, income taxes, and estate tax. While Virginia does not have an inheritance tax system, other local jurisdictions do, so it's important to be aware of the potential tax consequences if the decedent owned property in other states.

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