Life Insurance And Taxes: What's The Government's Cut?

Life insurance is a crucial financial product that provides peace of mind and financial security for individuals and their loved ones. While the primary purpose of life insurance is to offer a death benefit, it's essential to understand the tax implications associated with it. So, does the government tax life insurance? The short answer is that, in most cases, life insurance proceeds are not subject to income or estate taxes. However, there are certain scenarios where taxes may come into play.

Taxation of interest on death benefits

Taxation of life insurance death benefits varies depending on the type of insurance policy and the relationship between the insured, the policyholder, and the beneficiary. Here is some information regarding the taxation of interest on death benefits:

In most cases, death benefits paid out to beneficiaries are not considered taxable income and are tax-exempt. However, any interest earned on the death benefit is generally subject to tax. This includes cases where the death benefit is paid out in installments, and the remaining portion earns interest. The interest earned in such cases is taxable.

If the beneficiary receives the death benefit in installments that include interest, the interest will be taxable. The interest received is considered taxable income and should be reported accordingly.

Additionally, if the death benefit is paid to the insured's estate instead of directly to an individual or entity, it may be subject to estate tax. In 2024, estates over $13.61 million are subject to estate tax.

It is important to note that different states may have their own guidelines and regulations regarding taxes on life insurance policies. For example, Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are the only states that currently enforce an inheritance tax.

To avoid taxes on life insurance payouts, one strategy is to choose the beneficiary wisely. Designating the beneficiary as "payable to my estate" can increase the value of the estate and make it more likely to exceed the tax exemption threshold. Instead, naming a person as the beneficiary can lower the chances of being taxed.

Taxation of life insurance payouts to estates

Estate and Inheritance Taxes:

In the United States, if the beneficiary of a life insurance policy is an estate rather than an individual, the proceeds may be subject to estate taxes. According to Section 2042 of the Internal Revenue Code, the value of life insurance proceeds is included in the gross estate if payable to the estate or to named beneficiaries if the deceased had any "incidents of ownership" in the policy at the time of death. The basic exclusion amount for an estate in 2022 was $12.06 million, and $12.92 million for 2023, with a top tax rate of 40%. However, not all estates are subject to taxes.

Interest Accumulation:

If the beneficiary receives the life insurance proceeds after a period of interest accumulation rather than immediately, they may have to pay taxes on the interest accrued. This is because income earned in the form of interest is generally taxable, and the beneficiary is taxed on the interest portion of the benefit.

Transfer of Ownership:

To avoid estate taxes on life insurance proceeds, individuals can transfer ownership of the policy to another person or entity. This strategy is commonly done through an irrevocable life insurance trust (ILIT), where the policy is held in trust, and the proceeds are not included in the estate. However, it's important to note the three-year rule, which states that gifts of life insurance policies made within three years of death are still subject to federal estate tax.

State-Specific Considerations:

It's important to consider state-specific regulations and guidelines regarding taxes on life insurance policies. For example, Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania enforce an inheritance tax on any inherited cash payouts, properties, and other assets.

Tax Professionals:

Given the complexity of taxation laws, it is always advisable to consult with a tax professional to ensure compliance with federal and state regulations and to explore options for minimising tax liability.

Inheritance tax

In most cases, beneficiaries do not need to pay taxes on their life insurance payout. However, while most payouts are tax-free, there are exceptions. If the death benefit is paid out in instalments and the remaining portion earns interest, that interest would be taxable.

A life insurance payout might also be taxable if it is paid to the insured's estate instead of an individual or entity. If the money is paid to the insured's estate rather than a particular beneficiary, it could be taxable. For example, in 2024, estates over $13.61 million owe estate tax.

If the owner of the policy is not the same as the insured, the payout to the beneficiary could be considered a taxable gift.

To avoid paying any taxes on life insurance proceeds, a taxpayer will need to transfer ownership of the policy to another person or entity.

Taxation of cash value in life insurance policies

Taxation of Cash Value Accumulation

The cash value component of permanent life insurance policies, such as whole life and universal life insurance, grows tax-free. This means that the cash value accumulation within the policy is generally not taxable. However, certain policies, such as variable universal life insurance, allow policyholders to allocate cash and design their investment strategies, which may impact the tax treatment.

Taxation of Withdrawals and Loans

Withdrawals from the cash value of a life insurance policy are generally not taxable up to the total amount of premiums paid. However, if the withdrawal exceeds the total premiums paid, the gains or dividends may be taxed as ordinary income. Similarly, taking out a loan against the cash value is typically not taxable, but if the policy terminates before the loan is repaid, it may result in a tax liability.

Impact of Policy Type

The tax treatment of withdrawals and loans can also depend on the type of policy. Modified endowment contracts (MECs) are life insurance policies where the funding exceeds federal tax law limits. Withdrawals and loans from MECs may be taxed differently, and the earnings may be taxed first before the principal.

Surrendering or Cashing Out a Policy

Surrendering or cashing out a life insurance policy may incur taxes. If the cash value at the time of surrender exceeds the total premiums paid, the additional amount may be subject to income tax. Additionally, there may be surrender fees or charges associated with cancelling the policy, further reducing the net cash value.

Estate and Inheritance Taxes

Life insurance proceeds may be subject to estate or inheritance taxes if the value of the estate exceeds certain thresholds. Each state has its own regulations and guidelines regarding taxes on life insurance policies, and it's important to consider the impact of these taxes when planning your estate.

Tax Planning and Professional Advice

Due to the complexity of tax laws and the variety of life insurance policies available, it is essential to consult with a tax advisor or insurance professional. They can provide guidance on how taxes may affect your specific situation and help you make informed decisions about your life insurance policy.

Taxation of life insurance dividends

Dividends can be used in several ways, including taking them as cash, paying premiums, accumulating them inside the policy, or purchasing additional coverage. If you use the dividend options to purchase paid-up additions, reduce/pay future premiums, or buy additional term life insurance, there is no net taxable result. The net taxable result is a wash because there is no reduction or increase in your cost basis.

Withdrawing dividends from a whole life policy will first deduct from your cost basis. If you have a cost basis larger than the withdrawal, the withdrawal is non-taxable. However, if you withdraw more from the whole life policy than you paid in premiums, you will owe ordinary income taxes on the excess amount.

Any cash value in a whole life policy that you either withdraw or receive through a full policy surrender will be taxable. According to the U.S. Tax Code, all cash values are treated the same, regardless of their source (dividends, elective paid-up additions, and/or guaranteed cash value accumulation). In all cases, you will owe no taxes on the portion representing your cost basis.

Additionally, a taxable event only occurs if you make a withdrawal or full policy surrender. Cash inside a whole life policy is not taxable when it remains in an active/in-force whole life policy.

If you use dividends from one life insurance policy to pay dividends on another life insurance policy, it could eventually make the dividend payment taxable as ordinary income. The dividends used will count as cost basis for the other life insurance policy, and any withdrawal or dividend received as cash carries no tax liability unless you remove its full cost basis.

It is important to note that the taxation of life insurance dividends can be complex, and specific situations may vary. It is always recommended to consult with a tax professional or financial advisor for personalized advice.

Frequently asked questions