Paul Sanchez
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, 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 or covering funeral costs. However, there are a few situations where taxes could come into play, and it's important to be aware of these exceptions. For example, if your beneficiaries choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. Additionally, if a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, this could trigger estate taxes if the estate's total value is above the tax exemption amount. Understanding these nuances can help ensure that your beneficiaries receive the full benefit of the life insurance policy and are not burdened with unexpected tax liabilities.
What You'll Learn
Interest on life insurance payouts is taxable
Life insurance payouts are generally not considered taxable income. However, there are certain situations where taxes can come into play. One such instance is when the payout is structured as multiple payments over time, such as an annuity. In this case, the payments include both proceeds and interest. While the proceeds are not taxable, any interest accrued is considered taxable income.
For example, if a beneficiary elects to receive the policy amount in installments, the benefit is placed into an account that can earn interest. The beneficiary will not pay taxes on the benefit itself but will be responsible for paying income taxes on any interest earned. This means that if a beneficiary chooses to receive the life insurance payout in installments instead of a lump sum, they will need to pay taxes on the interest that accumulates on those payments.
In the case of cash value life insurance, policyholders can borrow or withdraw money from the policy's cash value. If the amount withdrawn is more than the total amount of premiums paid, the excess may be subject to taxation. Additionally, if there are any unpaid loans against the policy when it is surrendered or lapses, these will be deducted from the death benefit, reducing the amount paid out to beneficiaries.
When a life insurance policy is included as part of the deceased's estate, it may be subject to estate taxes if the total value exceeds certain thresholds. In the United States, the federal estate tax exemption is currently $12.92 million for an individual and nearly $26 million for a married couple. Some states also have lower estate tax thresholds, ranging from $1 million to $9.1 million. If the value of the estate, including life insurance proceeds, is above these exemptions, any amount above the threshold would be subject to estate taxes.
While life insurance payouts are generally tax-free, it is important to consider the potential tax implications in certain situations. By understanding these exceptions, beneficiaries can make informed decisions and avoid unexpected tax liabilities.
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Estate tax
About a dozen states in the US have state estate taxes with exemptions varying between $1 million and $9.1 million. These include Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania.
If you own a life insurance policy when you pass away, the death benefit becomes part of your taxable estate. This could push your estate's total value above the federal estate tax exemption, triggering estate taxes. While this generally impacts only high-net-worth individuals, some states have a state estate tax as well, and the thresholds are typically lower, so it's important to factor that into your planning. Working with an estate planner can help minimize these tax implications and ensure your loved ones receive as much of the death benefit as possible.
To avoid estate taxes, it is recommended to choose your beneficiary wisely. Making the beneficiary "payable to my estate" can raise the value of the estate above the threshold, making taxes more likely. If you name a person, there is a less likely chance of being taxed.
Consulting with a tax professional can help lower your tax liability. One of the main ways to remain protected is to name the beneficiary as an irrevocable life insurance trust. This keeps the cash value away from being lumped into the estate value. In this case, the value of the life insurance policy can be distributed amongst any beneficiaries listed in the trust. This option may shield beneficiaries from paying taxes on life insurance.
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Inheritance tax
In most cases, life insurance payouts are not taxed. However, inheritance tax may be applicable in certain situations. Inheritance tax is levied on the recipient of any inherited cash payouts, properties, and other assets. Currently, Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are the only states that enforce this tax.
If you are the beneficiary of a life insurance policy, you may wonder if you need to pay taxes on the payout. The payout from a term, whole, or universal life insurance policy is generally not considered part of the beneficiary's gross income and is therefore not subject to income or estate taxes. However, there are some instances where taxes may apply.
If the payout is structured as multiple payments, such as an annuity, the payments can be subject to taxes. These payments include proceeds and interest, and the interest portion is considered taxable income. Similarly, if the policyholder has withdrawn money or taken out a loan against the policy, and the amount withdrawn exceeds the total premiums paid, the excess may be taxable.
When surrendering a life insurance policy, the amount received is usually considered a tax-free return of the principal. However, any funds exceeding the policy's cash basis will be taxed as regular income. Additionally, in some cases, an employer-paid plan that pays out more than $50,000 may be taxable according to the Internal Revenue Service (IRS).
It is important to note that each state has its own set of guidelines regarding taxes on life insurance policies. To ensure compliance with tax laws, it is recommended to consult with a tax professional or financial advisor regarding your specific situation.
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Generation-skipping tax
The generation-skipping transfer (GST) tax is a federal tax imposed on assets gifted to heirs more than one generation younger than the grantor, typically grandchildren or great-grandchildren. Transfers to your children are not considered generation-skipping. This tax is separate from the estate tax and is only enforced when the assets exceed a certain threshold. The threshold for 2024 is $13.61 million per individual, and in 2025, it will be $13.99 million per individual. The GST exemption amount will grow each year based on inflation through 2025 and will revert to a $7 million baseline in 2026.
The GST tax is paid by the grantor if using a direct generation skip strategy, or by the beneficiary if using a generation-skipping transfer strategy. It is important to note that the tax only applies to assets above the lifetime exemption amount. The GST tax rate applies to outright transfers of property and certain other transfers of property to a trust. Generally, trust income or principal distributed to grandchildren is subject to GST.
There are two main generation-skipping transfer strategies: direct generation skip and generation-skipping transfers (or indirect generation skip). In a direct generation skip, you bypass your children and give the assets directly to your grandchildren, either as a gift or by placing them in a trust for their benefit or for future generations. In generation-skipping transfers, you place assets in a trust using your GST tax exemption. The trust pays your child income for life, and the remainder passes outside of your child's taxable estate to your grandchildren or future generations after your child's death.
To avoid paying GST, you can take advantage of the lifetime exemption from the GST tax, which can be applied to any combination of transfers during your life or at the time of death. Another strategy is to make the beneficiary "payable to my estate," but this can raise the value of the estate above the threshold, making taxes more likely. Consulting with a tax professional is advisable to determine the best strategy for your specific situation.
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Gift tax
If you give a permanent life insurance policy to another person, including a beneficiary, the IRS treats the transaction as a gift. That means that, depending on the policy's worth, the transfer could be taxed. However, term life insurance policies do not have a cash value, so transferring one won't trigger a gift tax, but it could trigger an estate tax.
Under 2024 gift tax rules, if you transfer a policy with a fair market value of more than $18,000 to another person, gift taxes will be assessed. However, the gift tax won't have to be paid until your death and will only need to be paid if your estate exceeds the federal gift and estate tax exemption ($13.61 million, or $27.22 million for married couples, for deaths in 2024).
The fair market value is not necessarily the same as the cash value. To find out the present fair market value of an insurance policy for gift tax purposes, ask your insurance company.
It is important to note that the amount of gift tax will be far less than the amount of estate tax that would be due if your policy remained in your name and in your estate. The policy proceeds are always considerably more than the value of the policy while the insured is alive.
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Frequently asked questions
Life insurance benefits are typically paid to the beneficiary in a lump sum, which is not taxable. However, if the beneficiary elects to receive the policy amount in installments, the benefit is placed into an account that can accrue interest. While the beneficiary will not pay taxes on the benefit itself, they will be responsible for paying income taxes on any interest accrued.
The death benefit of a life insurance policy is usually paid directly to the beneficiaries named. However, if the benefit is included in the estate, it is subject to potential Federal and State estate taxes if it is above the tax exemption amount. The Federal exemption is currently $12.92 million for a single person and nearly $26 million for a married couple.
Policy riders are optional features that can be added to a life insurance policy to help cover life events that a standard policy does not. These riders are typically not subject to taxes but would reduce the amount that your beneficiary receives.
A life insurance death benefit would be subject to taxes in the event of a taxable gift. This happens when three people serve three different roles in connection to the policy: the policyholder, the insured, and the beneficiary. If the insured passes away and the beneficiary receives the death benefit, the IRS considers this a taxable gift from the policyholder to the beneficiary. This is also known as a "Goodman Triangle", and in this case, the policyholder may have to pay gift taxes for any benefit amount that exceeds Federal gift tax exemption limits.
