Life Insurance And Taxes: What's The Connection?

Life insurance is a financial product that pays out a lump sum in the event of the policyholder's death, providing financial support to their beneficiaries and dependents. While the death benefit coverage is usually tax-free, there are certain circumstances where taxes may be incurred.

In most cases, money paid out from a life insurance policy is not taxable, but there are some exceptions. For example, if the contract changes ownership for cash or other valuable consideration, the payout may be subject to taxation. Additionally, if the death benefit is paid to the estate of the insured or if the deceased person owns the policy on the date of death, the proceeds may be subject to estate taxes.

Interest generated from life insurance policies is also taxed. While interest generated from whole life insurance policies is not taxed until the policy is cashed out, any interest earned on dividends is taxable. Furthermore, if your employer pays for your life insurance, the premium paid on policy amounts above $50,000 is considered part of your taxable income.

Life insurance premiums are generally not tax-deductible, but there are some exceptions. For instance, if you are not directly or indirectly a beneficiary of the policy, you may be able to deduct the premiums as a business expense.

Overall, while life insurance proceeds are typically tax-free, careful consideration of the specific circumstances is necessary to understand the potential tax implications.

Interest on life insurance payouts

Life insurance is often seen as a reliable way to provide for your loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. Typically, 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, covering funeral costs, or securing their future. However, there are a few situations where taxes could come into play, and it's important to understand how interest on life insurance payouts might be affected.

While the death benefit from a life insurance policy is generally not taxed, any interest that accumulates on those payments is considered taxable income. This means that if your loved ones choose to receive the life insurance payout in installments instead of a lump sum, they should be prepared to report and pay taxes on the interest portion of those payments. This is because the interest earned is seen as a form of income, even though the original death benefit is not.

For example, let's say you have a life insurance policy with a death benefit of $1,000,000. If your beneficiaries choose to receive the payout in installments over a period of 10 years, they will likely receive the payments with interest. Suppose the insurance company pays 3% interest on the death benefit. In that case, your beneficiaries will receive annual payments of $103,000, with $3,000 of each payment being considered taxable income. This means they will need to report and pay taxes on the $3,000 interest portion for each year of the installment period.

It's important to note that the specific rules and regulations regarding life insurance and taxes can vary depending on your location. In the United States, the Internal Revenue Service (IRS) provides guidance on reporting and paying taxes on life insurance proceeds and any associated interest. Additionally, it's always a good idea to consult with a tax professional to ensure you understand the tax implications of your specific life insurance policy and how they may affect your beneficiaries.

Other Tax Implications of Life Insurance:

In addition to the potential taxes on interest from life insurance payouts, there are a few other situations where taxes could impact your life insurance proceeds:

• Estate Tax: If your life insurance policy is included in your taxable estate, and the total value exceeds the federal estate tax exemption, your beneficiaries may have to pay estate taxes on the proceeds. Currently, the federal estate tax exemption is $13.61 million for 2024, but it can change from year to year.
• Inheritance Tax: This tax is levied on the recipient of any inherited cash payouts, properties, or other assets. Only a few states in the US enforce this tax, including Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania.
• Income Tax: Life insurance proceeds are typically not considered taxable income by the government. However, in certain situations, such as when the beneficiary is not a direct family member, taxes may be imposed.
• Generation-Skipping Tax: Similar to the estate tax, this tax is imposed on any assets that skip a generation and only comes into play when the value exceeds the same threshold as the estate tax.

Life insurance and estate taxes

Life insurance death benefits are typically tax-free, but there are some exceptions.

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 ($13.6 million in 2024), triggering estate taxes. While this generally impacts only high-net-worth individuals, some states have a lower threshold for state estate tax, so it's important to factor that into your planning.

If you have a will or trust in place and name your estate as the beneficiary of your policy, the life insurance payout can be used to pay estate taxes. But if you choose one or more individuals as beneficiaries, they won't be held liable for estate tax—they will receive the life insurance payout tax-free, and estate taxes will be paid from other assets you owned.

In addition to the federal estate tax, some states levy their own estate or inheritance taxes. Exemption limits vary among states. For example, New York's estate tax kicks in after $6.94 million.

If you are a high-net-worth individual with a sizable estate, you can keep your life insurance death benefit from being counted as part of your estate by transferring ownership to an irrevocable life insurance trust (ILIT) and paying premiums out of the trust account. This puts the policy and the disbursement of the payout under the trust's control, so it's excluded from the value of your estate.

With ILITs, the rules are complex and must be followed to the letter. For example, the three-year rule states that a policy is still part of your estate if a transfer of ownership occurs within three years of your death.

The death benefit may also be subject to gift tax if different people fill each of the policy's three roles: the insured, the policy owner, and the beneficiary. In most cases, only two people are involved. However, if a different person fills each role, the IRS considers the death benefit a gift from the policy owner to the beneficiary. For instance, if you buy a policy to cover your spouse's life and your child is the beneficiary, the death benefit is technically a gift from you (the owner) to your child (the beneficiary). As the policy owner, you're considered the donor and could be liable for gift tax.

Life insurance and gift tax

Life insurance proceeds are generally not taxable, but there are some situations in which they can be taxed. If you own your life insurance policy, it could be subject to estate and gift taxes.

Transferring Ownership

If you want to avoid federal estate tax on your life insurance proceeds, you can transfer ownership of your policy to another person or entity. This could be the policy beneficiary or an irrevocable life insurance trust (ILIT). However, the new owner must pay the premiums. Additionally, transferring ownership is irreversible—once the policy is transferred, the original owner loses all rights to make changes.

Incidents of Ownership

Even if you transfer ownership of your life insurance policy, the IRS may still consider you the owner if you retain any "incidents of ownership". This includes the legal right to:

• Change or name beneficiaries
• Borrow against the policy
• Pledge any cash reserve, or cash it in
• Surrender, convert, or cancel the policy
• Select a payment option

Three-Year Rule

The IRS's three-year rule states that gifts of life insurance policies made within three years of death are still subject to federal estate tax. Therefore, if you die within three years of transferring your policy, the proceeds will be included in your estate as if you still owned the policy.

Gift Tax

If you give a permanent life insurance policy to another person, the IRS treats this as a gift and it may be subject to gift tax. The fair market value of the policy, rather than the cash value, determines whether gift tax will be assessed. In 2024, if you transfer a policy with a fair market value of more than $18,000, gift taxes will be assessed. However, the gift tax doesn't have to be paid until your death and only if your estate exceeds the federal gift and estate tax exemption.

Cash value in life insurance policies

Cash value life insurance is a type of permanent life insurance policy that can build funds over time through the cash value component. The two main components that make up a life insurance policy are the death benefit and the cash value. The death benefit is the part of the plan that the beneficiaries receive, while the cash value portion can be accessed early by the policyholder. This can be done by taking out a loan against the policy, surrendering the policy, or making a withdrawal.

The cash value of a life insurance policy grows in a tax-deferred account, and this growth is generally not taxed until the policy is cashed out. The cash value of most whole life insurance policies grows over time and is considered income to the policyholder, so it has income tax implications. When a policyholder elects to take the cash value of their whole life insurance policy, the amount they are taxed on is the difference between the cash value they receive and the total they paid in premiums during the time the policy was in force.

There are several types of life insurance policies that may have a cash value portion, including whole life insurance, universal life insurance, variable life insurance, and indexed life insurance. Whole life insurance is a type of permanent insurance that lasts the entire life of the policyholder, with premiums being paid regularly. The cash value of whole life insurance can still grow with potential tax savings, and the death benefit is guaranteed as long as the premiums are paid.

Universal life insurance allows the policyholder to change the value of premium payments, providing more adjustability. The cash value of a universal life insurance policy can be used to pay for the premiums or other expenses. Variable life insurance provides greater access to investment tools, like cash value, but it tends to involve more risk as the cash value will grow or diminish depending on the performance of the chosen investments. Indexed life insurance has a greater relationship with the stock market, as this is used to determine growth. While there is a certain level of risk involved in an indexed universal life insurance plan, a guaranteed minimum interest rate can typically still be secured.

The benefits of cash value life insurance include lifelong coverage, flexible access to funds, and reasonable premiums. Cash value life insurance offers lifelong coverage, meaning it lasts the entire life of the policyholder. It also provides flexible access to funds, as the policyholder can use the funds from the cash value component while still alive. Additionally, the premiums for cash value life insurance policies are generally reasonable and may fit within your budget.

Group term life insurance

The typical coverage amount is equal to the annual salary of each employee, but an employer can pick different benefit levels. The benefit level can be a flat amount—like $50,000, for example. Often, there is an option for extra coverage if the employee wants to pay the additional premiums.

A portion of the premium for group term life insurance is often tax-free. Up to $50,000 of coverage for each employee is usually considered a tax-free benefit. Coverage over that amount must be recognised as a taxable benefit and included on an employee's W-2 form.

Employers that pay for their employees' benefits may be eligible for tax benefits for the business itself. Consult a tax professional to see what this might mean for your business and your employees.

Frequently asked questions