Life Insurance And The Irs: Do They Ask For Payouts?

Life insurance payouts are generally not taxable, but there are some exceptions. If the beneficiary receives interest on the payout, they will be taxed on the interest, not the entire benefit. If the payout is made to the insured person's estate, rather than a named individual, inheritance or estate taxes may apply. If the owner of the policy is not the same as the insured, the payout could be considered a taxable gift. To avoid paying taxes on a life insurance payout, you can transfer ownership of the policy or set up an irrevocable life insurance trust (ILIT).

Interest on life insurance proceeds

Life insurance proceeds are generally not taxable as income. However, any interest accrued on the proceeds is taxable and must be reported as interest received.

If you are the beneficiary of a life insurance policy and receive the payment as a series of installments, the insurer will typically pay interest on the outstanding death benefit. In this case, you would have to pay income tax on the interest.

If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated during that time.

To avoid paying taxes on the interest, ensure that the proper documentation and reporting requirements are met in a timely manner.

It is important to note that different rules and regulations may apply depending on your specific location and situation. It is always recommended to consult with a tax professional or financial advisor for personalized advice.

Estate tax

Life insurance proceeds are not usually subject to income tax. However, there are some instances where the beneficiary may be taxed on the payout.

An estate tax is a tax on your right to transfer property upon your death. Your life insurance proceeds may be taxable if your estate is worth more than the maximum threshold allowed. The threshold for 2023 is $12.92 million, and the top tax rate is capped at 40%. If your estate exceeds the threshold, your heirs may be subject to exceptionally high estate taxes.

To avoid this, you can transfer ownership of your life insurance policy to another person or entity, such as an irrevocable life insurance trust (ILIT). This removes the proceeds from your taxable estate, as they are no longer considered part of your estate. However, if you die within three years of the transfer, the proceeds will still be included in your estate and taxed accordingly.

Another option is to name a person as the beneficiary of your life insurance policy, rather than your estate. This reduces the likelihood of your beneficiaries being taxed.

Inheritance tax

If you live in one of the six states that enforce this measure, you may be subject to inheritance tax if you are the beneficiary of a life insurance policy. However, there are some strategies you can use to avoid paying taxes on a life insurance payout.

One way to avoid inheritance tax is to transfer ownership of the policy to another person or entity. This removes the policy from your estate, and any taxes would be based on the new owner's estate. Note that if you transfer ownership within three years of your death, the IRS will treat it as if you still owned the policy.

Another way to avoid inheritance tax is to set up an irrevocable life insurance trust (ILIT). The trust will own the life insurance policy instead of you, and the proceeds will not be included in your estate. However, this type of trust cannot be revoked after it is set up.

Additionally, it is important to be aware of gift tax limits. In 2024, the annual gift tax exemption is $18,000, and the lifetime exclusion amount is $13.61 million. If the policy's cash value does not exceed these limits, you may be able to avoid inheritance tax.

Generation-skipping tax

The generation-skipping transfer tax (GSTT) is a federal tax on transfers of assets or property to individuals (or to a trust for their benefit) that are more than one generation below the transferor. This includes transfers from a grandparent to a grandchild or to other individuals who are more than 37.5 years younger than the transferor (the "skip" generation). The GSTT was introduced in 1976 to prevent wealthy families from avoiding estate taxes at the death of each generation.

The GSTT is equal to the highest federal gift and estate tax rate at the time of the transfer (40% in 2024) and is in addition to any other federal gift or estate tax that may be owed. The GSTT is imposed only if the transfer avoids incurring a gift or estate tax at each generation level. The Internal Revenue Service (IRS) imposes a second layer of tax on gifts and bequests above the estate and lifetime gift exclusion.

The taxation of a GST depends on whether the transfer is a direct or an indirect skip. A direct skip is a property transfer that's subject to an estate or gift tax. The transferor or their estate is responsible for paying the GST tax for direct skips. An example of a direct skip would be a grandmother gifting property to a grandchild.

An indirect skip involves a transfer that has intermediate steps before reaching a skip person. There are two types of indirect skips: the taxable termination and the taxable distribution. A taxable termination involves a skip person and a non-skip person. The transfer to the skip person occurs upon the death of a non-skip person—typically the child of the transferor. A taxable distribution refers to any distribution of income or property, from a trust to a skip person that is not otherwise subject to estate or gift tax.

The lifetime exemption from the GST tax may be applied to any combination of transfers during one's lifetime or made at the time of death. The GST tax does not apply to qualified non-taxable gifts, including annual exclusion gifts of up to $18,000 per recipient per year and payments for tuition, medical care, or medical insurance made directly to a school, doctor, hospital, etc.

Tax on cash value of policy

The cash value of a life insurance policy is generally not taxable as it grows within the policy. However, there are certain situations where taxes may apply.

Withdrawals

You can withdraw up to the amount of the total premiums you've paid into the policy without paying taxes. However, if you withdraw any gains, such as dividends, these are taxed as ordinary income.

Policy Loans

If you take out a loan from your life insurance plan, it won't be taxable as long as the policy is still in force. However, if the policy terminates before the loan is repaid, you may be taxed on the outstanding loan balance.

Cashing Out

If you cash out or surrender your policy, you may be taxed on the amount you receive minus the policy basis (the total premium payments you've made). This taxable amount reflects any investment gains you've made.

Interest

Interest earned on beneficiary life insurance proceeds or periodic (annuity) payments is generally taxable.

Frequently asked questions