Life Insurance Payouts: Are Arizonans Taxed On Benefits?

Life insurance payouts are usually tax-free, but there are exceptions. For example, if the payout is paid in instalments and the remaining portion earns interest, that interest is taxable. The payout might also be taxable if it's paid to the insured's estate instead of an individual or entity. Each state has its own set of guidelines regarding taxes on life insurance policies.

• If the payout is paid to the insured's estate instead of an individual or entity.
• If the owner of the policy is not the same as the insured. | | How can beneficiaries avoid paying taxes on a life insurance payout? | - Transfer ownership of the policy.
• Set up an irrevocable life insurance trust (ILIT).
• Be aware of gift tax limits. |

Interest on life insurance payout

Life insurance is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person passes away. While most life insurance payouts are tax-free, there are some situations in which the interest on the payout may be taxable.

Interest on Installments

If the death benefit from a life insurance policy is paid out in installments rather than a lump sum, any interest that accumulates on those payments will be taxed as regular income. The death benefit itself is typically not taxed, but beneficiaries should be prepared to report the interest on their taxes.

Retained Asset Account

The insurance company may provide the beneficiary with a checkbook so they can access the cash in the account. The insurer may also offer an interest income option, but the beneficiary will only be paid the interest earned on the death benefit amount. This interest is taxable.

Life Income with Period Certain

This option allows the policyholder to ensure that payments will continue to be made for a certain period of time even if they die. For example, if the policyholder chooses a 10-year period and dies in year three, beneficiaries will continue to receive payments for another seven years. While this option provides peace of mind, the payments will be lower than with a traditional life income option.

Specific Income Payout

This option allows the policyholder to receive a life insurance payout in installments. The policyholder can choose the time period over which they want to receive payments and the amount of the payments. For example, if they receive a $250,000 life insurance payout, they could choose to receive $25,000 per year for 10 years. While this option provides flexibility, any interest earned will be taxable.

Tax Implications for the Beneficiary

If the beneficiary receives interest on the life insurance payout, this is taxable and should be reported as interest received. 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 may be some exceptions to this rule.

Estate tax

An estate tax is a tax on your right to transfer property upon your death. In most cases, life insurance proceeds are not considered taxable income, and the beneficiary does not have to report the payout on their taxes. However, there are some circumstances where the money is taxable.

One such circumstance is when the beneficiary receives interest. While the lump-sum proceeds of the life insurance policy are typically not taxable, any interest earned on the death benefit is considered taxable income.

Another circumstance where a beneficiary may have to pay taxes on a life insurance payout is when the money is paid to an estate. If the money is paid to the insured's estate rather than a particular beneficiary, it may be taxable. In 2024, estates over $13.61 million owe federal estate tax. Additionally, twelve states and the District of Columbia impose an estate tax, with exemption limits ranging from $1 million in Oregon to $13.61 million in Connecticut.

To avoid paying estate tax on a life insurance payout, it is recommended to choose a beneficiary wisely. Making the beneficiary "payable to my estate" can increase the value of the estate and make taxes more likely. Instead, naming a person as the beneficiary can lower the chances of being taxed.

Inheritance tax

In most cases, beneficiaries do not pay taxes on their life insurance payout. However, there are some exceptions.

The inheritance tax is a tax placed on the recipient for any inherited cash payouts, properties, and other assets. Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are currently the only states that enforce this tax.

Instances where beneficiaries may have to pay taxes on life insurance include:

• The policy accrued interest. If life insurance proceeds have accumulated some interest, taxes are usually due. Fortunately, only the amount that earned interest will be taxed, rather than the entire death benefit.
• The policyholder names the estate as a beneficiary. In this case, the taxes loved ones may pay depend on the estate's value.
• The insured and the policy owner are different individuals. If a different person holds each role, there may be taxes involved.

There are some strategies beneficiaries can use to avoid paying taxes on a life insurance payout:

• Use an ownership transfer. When an estate is involved, whether life insurance proceeds are taxable is based on the policy's ownership when the insured passes away. To avoid taxation, you can transfer ownership of your policy to another person or entity.
• Create an irrevocable life insurance trust (ILIT). If you set up an ILIT, it will own the life insurance policy rather than you. This means the proceeds will not be included in your estate. You can state how you’d like the beneficiaries to receive or use the payout.
• A gift tax comes into play if the life insurance policy’s cash value is higher than the gift tax exemption, which is $12.92 million or $17,000 per year as of 2023. It’s a good idea to ensure your cash value does not exceed this amount.

Income tax

In most cases, life insurance proceeds are not considered taxable income. However, there are some instances where the beneficiary may be taxed. Here are some scenarios where income tax may be applicable:

• Interest on Installments: If the beneficiary receives the death benefit in installments, any interest that accumulates on those payments will be taxed as regular income. The death benefit itself is typically not taxed, but the interest earned is considered taxable income.
• Payment to the Estate: If the life insurance policy names the estate as the beneficiary instead of a specific individual, the death benefit may be subject to estate taxes. In such cases, the taxes owed depend on the value of the estate.
• Different Insured and Policy Owner: If the owner of the policy is not the same as the insured, the payout to the beneficiary could be considered a taxable gift. This scenario can trigger a gift tax if the amount exceeds the annual exclusion limit, which is $18,000 for the year 2024.
• Employer-Paid Group Life Insurance: According to the IRS, if you are receiving proceeds from an employer-paid life insurance policy, any death benefit beyond $50,000 is taxed as income.
• Withdrawing from Cash Value: If you withdraw more money than you have paid in premiums from a whole life or universal life insurance policy, the excess amount may be taxed as income.
• Surrendering the Policy: When you surrender a life insurance policy, you will typically receive the cash surrender value, which is the policy's cash value minus any fees. Any cash value accrued will be taxed as income.

Generation-skipping tax

The GSTT was introduced in 1976 to prevent wealthy individuals from avoiding estate taxes by skipping children in favour of grandchildren. Prior to the GSTT, it was possible to pass assets to a trust for the benefit of multiple generations, avoiding estate taxes as each generation passed away. The GSTT ensures that grandchildren receive the same amount of assets as if the inheritance was coming from their parents.

The GSTT is imposed on three types of taxable events: direct skips, taxable distributions, and taxable terminations. Direct skips occur when assets are transferred from one individual to a skip person, either outright or in trust. Taxable distributions occur when a distribution of income or principal is made by a trust to a skip person. Taxable terminations happen when an interest in property held in trust terminates, and there are no other non-skip beneficiaries.

The GSTT exemption is $13.61 million for individuals and $27.22 million for married couples in 2024. This means that only transfers above these amounts are subject to the GSTT. The GSTT rate is a flat 40%.

To avoid the GSTT, individuals can make use of exemptions, such as the annual gift tax exclusion, which allows individuals to give up to $18,000 per year to an unlimited number of individuals without tax consequences. Another strategy is to create dynasty trusts, which are designed to avoid or minimise estate taxes with each generational transfer.

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