Life Insurance And Tax Credits: Missouri's Unique Benefits

Life insurance is a crucial financial safety net for your loved ones in the event of your passing. While it's generally not taxable, there are specific scenarios where taxes may apply. Understanding these exceptions can help beneficiaries avoid unexpected tax burdens. This is especially important when dealing with term life insurance, which has no cash value component, and permanent life insurance, which allows for withdrawals and policy loans.

Life insurance payouts are usually tax-free

For example, if the policyholder delays the benefit payout and the money is held by the insurance company for a given period, the beneficiary may have to pay taxes on any interest generated during that time. This is because income earned in the form of interest is almost always taxable. If the policyholder names an estate as the beneficiary, rather than an individual, the person or people who inherit the estate may have to pay estate taxes.

If the policy's cash value exceeds a certain amount, the beneficiary may also encounter an estate tax or a generation-skipping tax. In the US, the first $11.7 million of a life insurance benefit is not taxed at a federal level, but anything above this amount may be subject to taxation. Additionally, if the beneficiary lives in Iowa, Kentucky, Nebraska, New Jersey, Maryland, or Pennsylvania, they may have to pay an inheritance tax on the payout.

To avoid paying taxes on life insurance proceeds, a taxpayer can transfer ownership of the policy to another person or entity. They can also create an irrevocable life insurance trust (ILIT) to hold the policy, which would remove the proceeds from their taxable estate. Consulting with a tax professional can help individuals lower their tax liability and ensure they are taking the necessary steps to avoid unnecessary taxes.

Interest on life insurance payouts is taxable

In most cases, there is no tax on life insurance payouts. However, any interest accrued on the payout is taxable. This interest is calculated from the date of the insured person's death to the date the insurance company sends the death benefit check to the beneficiary. The insurance company reports the interest to the Internal Revenue Service (IRS), and the beneficiary must report it as interest received.

There are some instances where the beneficiary can be taxed on the payout. For example, if the cash value of the policy exceeds a certain amount, the beneficiary may have to pay estate tax or generation-skipping tax. Additionally, if the beneficiary is a third party, they may be taxed. For example, if a mother buys her daughter a life insurance policy and names the father as the beneficiary, the father would be taxed.

It is important to note that each state has its own set of guidelines regarding taxes on life insurance policies. For instance, Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are currently the only states that enforce an inheritance tax.

To protect your policy and ensure you are complying with tax laws, it is recommended that you choose your beneficiary wisely and consult with a tax professional.

Life insurance payouts can be taxable if part of an estate

Life insurance payouts are usually tax-free, but there are exceptions. If your policy's payout causes your estate's worth to exceed the federal estate tax exemption limit, your heirs might be charged estate taxes. This limit was $13.61 million for individuals in 2024.

If you die while holding a life insurance policy, the IRS will count the payout in the value of your estate, regardless of whether you name a beneficiary. The payout could push your estate's total taxable value over the limit, and your heirs would have to pay an estate tax on any assets above the threshold within nine months of your death.

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. However, if you choose 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 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 ensures that the disbursement of the payout is 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. To prevent your policy from being brought back into the estate, it's worth working with an advisor to set up the trust correctly. 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.

Cash value in life insurance policies is sometimes taxable

Life insurance policies with a cash value component, such as whole life and universal life insurance, allow the policyholder to accumulate cash value over time. This cash value grows tax-free and can be accessed by the policyholder through loans, withdrawals, or policy surrender. However, in certain situations, the cash value of a life insurance policy may be taxable.

Permanent life insurance policies, such as whole life and universal life, have both a death benefit and a cash value component. The cash value of these policies grows over time, providing a financial benefit to the policyholder. This cash value is generally not taxable, but there are some instances where taxes may apply.

One scenario where taxes may be incurred is when a policyholder takes out a loan from their life insurance plan. If the policy is surrendered or cancelled before the loan is fully repaid, the policyholder may be subject to a tax bill on the outstanding loan amount. Additionally, if the cash value of the policy is withdrawn, any gains or dividends will be taxed as ordinary income.

Another situation that may trigger taxes is when the policy is surrendered or cashed out. If the cash value of the policy exceeds the total premiums paid, the gain on that value is taxable. This is because the cash value includes both the premiums paid and any accumulated earnings or interest, which are subject to income tax.

It is important to note that life insurance proceeds received by a beneficiary due to the death of the insured person are generally not includable in gross income and do not need to be reported. However, any interest received on the proceeds is taxable and should be reported as interest income.

The taxation of life insurance policies can be complex, and it is always recommended to consult with a tax advisor or financial professional to understand how taxes may apply to your specific situation.

Group term life insurance is taxable over $50,000

Group term life insurance is a common benefit provided by employers. It is a type of life insurance policy that covers a group of people, often offered as part of an employee benefits package. While the premiums for this type of insurance may be paid by the employer, it can become a taxable benefit for employees when the coverage amount exceeds $50,000. This is because the Internal Revenue Code (IRC) provides an exclusion for the first $50,000 of group-term life insurance coverage under a policy carried directly or indirectly by an employer. This exclusion applies to both federal income tax and Federal Insurance Contributions Act (FICA) taxes, which include Social Security and Medicare taxes.

If an employee receives more than $50,000 of employer-provided group term life insurance coverage, the cost of the insurance above this threshold is included in the employee's gross income and is subject to FICA taxes. This is true even if the employees are paying the full cost of the insurance. The employer is considered to carry the policy if they pay any cost of the insurance or if they arrange for the premium payments and the premiums paid by at least one employee subsidize those paid by another employee (the "straddle" rule).

The taxable portion of the premiums for coverage that exceeds $50,000 must be calculated using the IRS Premium Table. This table is used to determine the cost of excess coverage based on the worker's age. For example, if an employee is 45 years old, their premiums would be calculated at 15 cents per month (or $1.80 a year) for every $1,000 in coverage above the $50,000 threshold.

Group term life insurance also has tax implications for coverage offered to an employee's spouse or dependents. If the amount of coverage for a spouse or dependent is $2,000 or less, it is not taxable to the employee. However, the premiums on coverage for spouses or dependents over this amount may be treated as taxable income for the employee. If the coverage exceeds $2,000, then the entire amount of the premium is considered taxable.

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