Life Insurance Payouts: Are They Taxed In Minnesota?

Life insurance is a crucial financial tool that provides peace of mind by ensuring your loved ones are taken care of in the unfortunate event of your demise. While the death benefit payout is generally not taxable in most states, including Minnesota, there are certain scenarios that can trigger tax liabilities for your beneficiaries. Understanding these exceptions is essential for effective financial planning. This paragraph aims to explore the taxation implications of life insurance payouts in Minnesota, highlighting strategies to minimize tax burdens and ensure a secure future for your family.

Interest accrued on life insurance payouts

In the case of a retained asset account (RAA), where the insurer holds the death benefit and provides the beneficiary with a checkbook to draw funds as needed, the interest earned may be subject to taxes.

In the state of New York, interest on life insurance payouts begins to accrue from the date of the insured's death, not from the date that the claim is fully filed with the insurer. This is in accordance with N.Y. Ins. Law § 3214(c) (McKinney 2000).

To avoid issues with interest accrual, life insurance payouts in Minnesota are typically made in one lump sum. However, if the policy opts to release the funds in payments, the funds may accrue interest while sitting in an account, and the beneficiary would be responsible for paying taxes on this interest.

Payouts from businesses that write off premiums

When it comes to life insurance, there are only a few narrow situations where premiums are tax-deductible for self-employed individuals. If you're self-employed, you typically cannot subtract your premium payments from your total income each year. However, there are some instances where life insurance premiums can be written off as a business expense.

As a business owner, you can offer life insurance policy coverage as an employee benefit. In this case, the premium payments could be tax-deductible depending on your business classification status. If you have a C corporation, the IRS prohibits taking any type of deduction on life insurance premiums.

For S corporations and LLCs, there are stipulations to take advantage of a life insurance tax-deductible business expense. Firstly, the company must offer a life insurance policy as an employee benefit via a group plan. If the plan is only available to executives, the premiums must be reported as wages. When the coverage reaches $50,000 or more, that amount must be listed as wages on the employee's W-2.

Another restriction is that you cannot deduct life insurance as a business expense if you are the beneficiary of the employee's policy. For example, a married couple running an S-corporation together cannot deduct their life insurance premiums if they list each other as beneficiaries.

While you usually cannot deduct life insurance premiums as a business expense, there is a significant tax advantage for the beneficiary when a policy pays out. This is because the proceeds are typically not included in the individual's gross income, so beneficiaries do not have to pay income tax.

In contrast, an inheritance may be subject to estate taxes, depending on the amount. This is one reason why life insurance can be valuable for those who want to transfer wealth to loved ones. While life insurance may not be part of a short-term tax strategy for writing off business expenses, it can be an attractive long-term tax solution to pass wealth to heirs without diluting it with taxes.

Other types of business insurance that may provide tax relief include liability insurance, business interruption insurance, and commercial property insurance. These policies can be deducted as business expenses, boosting protection while lowering overall tax liability.

Estates worth over $12.92 million

If your estate is worth over $12.92 million, you will have to pay federal estate taxes on the amount above that level. The federal estate tax rate is 40% as of the 2023 tax year. However, this rate can be reduced through various deductions, discounts, and loopholes.

Additionally, if you live in a state that has an estate tax, you will likely have to pay that as well. State estate taxes are levied by the state in which the deceased resided at the time of death, and the exemptions for these taxes are typically much lower than the federal exemption. For example, some states have exemptions as low as $1 million.

To minimize estate taxes, you can set up trusts, such as an irrevocable life insurance trust (ILIT), that facilitate the transfer of wealth. Another option is to transfer ownership of your life insurance policy to another person or entity, including the beneficiary. By doing so, the death benefit will not be included in your estate value, and your beneficiaries will avoid paying taxes on it.

Irrevocable Life Insurance Trusts (ILITs)

ILITs are structured between three legal parties: the grantor (who creates and funds the trust), the trustee (who manages the trust and pays the insurance premiums), and the beneficiary/beneficiaries (who will receive the trust assets upon the grantor's death).

By creating an ILIT, the grantor removes taxable assets from their estate and transfers them to a separate legal entity (the trust). The trustee then uses these assets to purchase a life insurance policy in the grantor's name and continues to pay the premiums. When the grantor dies, the policy's death benefit is paid directly to the trust, which will distribute the proceeds to the named beneficiaries.

ILITs are powerful planning tools that serve as an important wealth transfer mechanism in many well-crafted estate plans. They are particularly beneficial for affluent families with sizable estates, as they provide a tax-efficient way to transfer wealth to beneficiaries outside of the taxable estate. ILITs can also help protect legacy assets from potential creditors and ensure that beneficiaries remain eligible for government benefits such as Social Security Disability Income or Medicaid.

One of the main downsides of ILITs is that they are irrevocable, meaning the trust cannot be modified without legal action or the consent of the beneficiaries. This could have severe implications if the grantor unexpectedly needs access to the assets in the future.

Whole or universal life insurance

Whole life insurance is a permanent life plan that provides coverage throughout your entire life. The premiums are typically higher than those of a term plan and remain fixed throughout the duration of the plan. Whole life insurance also functions as an investment, with a portion of the premiums being placed in a tax-deferred account that grows at a constant rate. The death benefit is guaranteed, and the beneficiary will receive the accrued cash value of the plan upon the policyholder's death.

Universal life insurance is another form of permanent life insurance that offers more flexibility than whole life insurance. Policyholders can adjust their premiums and death benefits within certain limits. The cash value of a universal life insurance policy earns interest, which is set by the insurer and can change frequently, although there is usually a minimum rate. The interest-earning capability provides the potential for cash value growth, but there is also a risk of the cash value decreasing if investments underperform. Similar to whole life insurance, universal life insurance allows policyholders to borrow against the accumulated cash value without tax implications. However, unlike whole life insurance, the cash value and death benefits are not guaranteed with universal life insurance.

Both whole and universal life insurance offer lifelong coverage and have a cash value component. Whole life insurance provides more stability with fixed premiums and guaranteed cash value and death benefits. On the other hand, universal life insurance offers more flexibility with adjustable premiums and the potential for higher cash value growth, but there is also a risk of large payment requirements or policy lapse if the cash value drops too low.

In the state of Minnesota, a tax is imposed on life insurance. The tax rate for life insurance premiums is 1.5 percent of gross premiums less return premiums on all direct business received by the insurer or their agents in Minnesota during the year.

Frequently asked questions