Life Insurance Benefits: Are They Considered Income?

Life insurance payouts are usually tax-free, but there are exceptions. While beneficiaries generally don't have to report the payout as income, certain situations can lead to taxation, particularly if you earn interest on the proceeds or the policy owner had a high net worth. For example, if the beneficiary receives the life insurance payment as a series of installments, the insurer will typically pay interest on the outstanding death benefit, which is subject to income tax. Additionally, 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. It's important to understand how and when these taxes apply to avoid any surprises.

Interest on life insurance benefits

Life insurance benefits are generally not taxable as income. However, in certain situations, the beneficiary may be taxed on some or all of a policy's proceeds.

When Interest is Taxable

If the beneficiary receives the life insurance payment as a series of installments, the insurer will typically pay interest on the outstanding death benefit. In these cases, the beneficiary 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 period.

When Interest is Not Taxable

If the life insurance proceeds are paid out entirely as a lump-sum, one-time payment, the beneficiary does not have to pay taxes on the benefit.

If the beneficiary is the spouse of the deceased, the life insurance payout is not taxed and will be passed on to them fully. Spouses typically have an unlimited exemption with regards to estate taxes.

Interest Computation

Interest on life insurance proceeds is computed from the date of death of the insured to the date of payment. The interest rate is determined by the rate in effect as of the date of death, not by the rate in effect on the date of payment of proceeds.

Estate tax

In the US, life insurance benefits are generally not taxable. However, there are some situations in which life insurance benefits may be subject to estate tax. Here is an overview of how estate tax works and how it relates to life insurance benefits:

Life Insurance and Estate Tax

Life insurance benefits are generally not subject to estate tax. However, if the life insurance policy is owned by the deceased person's estate rather than by a specific beneficiary, the benefits may be included in the value of the estate for estate tax purposes. This can increase the value of the estate and potentially trigger estate tax liability.

To avoid this, individuals can transfer ownership of their life insurance policy to another person or entity, such as an irrevocable life insurance trust (ILIT). By transferring ownership, the life insurance benefits are removed from the taxable estate, reducing the potential estate tax burden on heirs. It is important to note that the timing of the transfer is crucial, as transfers made within three years of death may still be subject to estate tax under the three-year rule.

In summary, while life insurance benefits are generally not taxable, careful planning is needed to minimize potential estate tax liability. Transferring ownership of life insurance policies and ensuring that benefits are paid to specific beneficiaries rather than the estate can help reduce the tax burden on heirs.

Inheritance tax

In the US, the federal estate tax exclusion amount for a decedent who passed away in 2023 is $12.92 million, and the top-tier tax rate is capped at 40%. For 2024, estates over $13.61 million owe estate tax.

To avoid paying inheritance tax on life insurance proceeds, you can put your policy 'in trust'. This means appointing trustees, such as a solicitor, family members, or friends, to look after the policy on behalf of your beneficiaries. By writing your life insurance policy in trust, the payout will go directly to your beneficiaries and will not form part of your legal estate, thus avoiding inheritance tax. Setting up a trust is generally a straightforward process and can be done for free through your life insurance provider.

Generation-skipping tax

Generation-Skipping Transfer Tax (GSTT)

The generation-skipping transfer tax is a federal tax on gifts or inheritances that aims to prevent donors from avoiding estate taxes by skipping their children and gifting to their grandchildren instead. The GSTT ensures that grandchildren receive the same amount as if the inheritance came from their parents.

The GSTT was introduced in 1976 to close the loophole that allowed wealthy individuals to legally gift money and bequeath property to their grandchildren without paying federal estate taxes. The GSTT is imposed when there is a transfer of property by gift or inheritance to a beneficiary (other than a spouse) who is at least 37.5 years younger than the donor.

The GSTT tax rate is a flat 40%. Most people will not encounter the GSTT due to its high threshold: it only applies when the transferred amount exceeds $12.06 million per individual for 2022 and $12.92 million for 2023. This threshold is set to revert to around $7 million in 2026.

The GSTT is triggered when a person gifts an asset but skips a generation, for example, when a grandparent gifts a home to their grandchild, skipping the parent. The tax is paid by either the grantor or the skipped beneficiary, with the former being the most common scenario.

There are two types of GSTT: direct and indirect skips. A direct skip is a property transfer subject to an estate or gift tax, such as a grandmother gifting property to a grandchild. The transferor is responsible for paying the GST tax for direct skips. An indirect skip involves a transfer with intermediate steps before reaching a skip person, such as a taxable termination or a taxable distribution.

To avoid the GSTT, transferors can create dynasty trusts, which are designed to avoid or minimize estate taxes with each generational transfer. By placing assets in the trust, the corpus is not subject to estate taxes upon transfer.

Group term life insurance

Life insurance benefits are generally not considered taxable income. However, any interest accrued on the benefit is taxable.

• It provides financial security for employees and their families at an affordable price.
• Employers typically pay most or all of the premiums for basic coverage, with the option for employees to purchase additional coverage for themselves and their families.
• The standard amount of coverage is often tied to the employee's annual salary, with premiums based on the insured's age.
• Coverage is usually only valid while the individual remains employed with the company.
• Employers can deduct life insurance premium payments for up to $50,000 of coverage per employee, as long as the employer is not the beneficiary.
• Group term life insurance does not require employees to undergo a medical exam or underwriting process.
• It is important to note that group term life insurance may not provide sufficient coverage for all families, and additional individual coverage may be necessary.

Frequently asked questions