Life Insurance Payouts: Are They Taxed By The Us?

Life insurance payouts are usually tax-free, but there are some situations in which they are taxable. For example, if the beneficiary chooses to delay the payout or take the payout in instalments, interest may accrue, and the beneficiary may be taxed on this interest. If the payout goes into a taxable estate, it could be subject to both federal and state estate taxes. If the policy involves three different people – the insured, the policy owner, and the beneficiary – then the death benefit may be subject to gift tax. Whole life insurance and other permanent life insurance policies earn cash value over time, which is generally tax-free unless you withdraw more than the policy basis.

Taxation on accrued interest

When filing taxes, it is important to report the taxable amount based on the type of income document received, such as Form 1099-INT or Form 1099-R. Additionally, if the policy was transferred to the beneficiary for cash or other valuable consideration, the exclusion for the proceeds may be limited to the sum of the consideration paid, additional premiums paid, and certain other amounts.

To avoid taxation on accrued interest, beneficiaries can opt for a lump-sum payout immediately after the death of the insured, as interest generally accumulates when payouts are delayed. Additionally, creating an irrevocable life insurance trust (ILIT) can help minimize taxes, as the trust owns the policy, and the proceeds are not included in the estate.

It is worth noting that the taxation rules may vary based on the specific circumstances and the jurisdiction. Consulting with a tax professional or financial advisor can provide personalized guidance on navigating taxation on accrued interest in life insurance payouts.

Taxation on estate value

Estate Tax:

The estate tax, also known as the "death tax," is a federal tax levied on the transfer of a deceased person's estate. This includes property transferred by will or, if there is no will, according to state laws of intestacy. The estate tax also applies to transfers made through trusts, certain life insurance benefits, and financial accounts. The federal exemption for the estate tax in 2024 is $13.61 million, or $27.22 million for a married couple. Estates valued above these amounts may be subject to estate tax, but only on the amount exceeding the exemption. It's important to note that the estate tax is separate from any inheritance tax that may be levied by the state.

Deductions and Exemptions:

When calculating the taxable value of an estate, certain deductions are allowed to arrive at the "taxable estate." These deductions may include funeral expenses, administration expenses, claims against the estate, certain charitable contributions, and property left to a surviving spouse. Additionally, there is a "unified credit" that further reduces the tax liability. As a result, only a small fraction of estates in the US end up paying any estate tax.

State-Level Estate and Inheritance Taxes:

It's important to consider state-level estate and inheritance taxes, as these can vary from state to state. Currently, fifteen states and the District of Columbia have an estate tax, while six states have an inheritance tax, and Maryland has both. State estate tax exemption amounts can range from the federal level ($13.61 million in 2024) to as low as $675,000. On the other hand, inheritance taxes are paid by the inheritors of the estate, and the tax rate depends on their relationship to the deceased.

Strategies for Reducing Estate Taxes:

There are several strategies individuals can use to reduce their estate taxes:

• Spending assets during their lifetime
• Gifting parts of their estate to loved ones while they are still alive, as many states don't tax gifts
• Donating property to qualifying charities
• Shielding assets in an irrevocable trust
• Moving to a state with more favorable tax laws

Life Insurance and Estate Taxes:

While life insurance death benefits are typically not taxable, certain situations can trigger tax liability. If the beneficiary chooses to delay the payout or receive it in installments, the interest accrued may be taxable. Additionally, if no beneficiary is named or the named beneficiary is deceased, the life insurance payout goes into the estate and can be taxable along with the rest of the estate.

Taxation on cash value

Cash value life insurance policies, such as whole life and universal life insurance, offer both a death benefit and a savings component. The savings component, known as cash value, allows policyholders to build wealth over time. While the cash value generally grows tax-free, taxes may apply when accessing this money. Here are some scenarios where taxation on cash value withdrawals may occur:

• Withdrawing Above the Policy Basis: When you withdraw funds from the cash value account, the portion that comes from premium payments is generally not taxable. However, any amount withdrawn above the policy basis, which includes investment gains or interest earnings, is typically subject to income taxes.
• Modified Endowment Contracts (MECs): If you pay extra premiums above the amount needed to fund the policy within seven years, your policy may be reclassified as a MEC. In this case, the tax benefits associated with traditional cash value life insurance policies no longer apply, and withdrawals are taxed differently.
• Early Withdrawals: If you are under 59½ years old and make withdrawals from a MEC, you may also be subject to a 10% early withdrawal penalty in addition to income taxes.
• Policy Loans: Borrowing against the cash value of your life insurance policy is usually not taxable as long as the policy remains in force. However, if the policy terminates before the loan is repaid, you may be taxed on the portion of the loan that exceeds your policy basis (interest or investment earnings).

Taxation on Surrendering or Selling the Policy:

When you surrender or sell your life insurance policy, you may receive a cash payout. Here's how taxation works in these scenarios:

• Surrender Charges: Surrendering your policy may incur surrender charges or fees, which vary depending on the insurance company and the age of the policy. These fees are deducted from the cash payout you receive.
• Taxation on Surrender Value: If you surrender your policy, you will generally be taxed on the amount you receive above your policy basis. This means that any investment gains or interest earnings included in the surrender value will be subject to taxes.
• Viatical and Life Settlements: Selling your life insurance policy to an investor, especially if you are terminally ill, can provide immediate cash benefits. Viatical settlements, where the seller is terminally ill, are typically not taxable. However, life settlements, where the seller is healthy, may result in taxable income for the seller.

Estate Taxes on Life Insurance Proceeds:

Life insurance proceeds may be subject to estate taxes if they are included in your taxable estate. This can occur if the beneficiary passes away before you or if you fail to name a beneficiary. In such cases, the death benefit proceeds may go directly to your estate, increasing its value and potentially triggering estate taxes for your heirs.

Avoiding Taxation on Cash Value:

To avoid paying taxes on the cash value component of your life insurance policy, consider the following strategies:

• Withdraw Within the Policy Basis: By limiting your withdrawals to the amount you have paid in premiums (the policy basis), you can generally avoid taxation.
• Maintain Policy in Force: Keep your policy active to avoid taxation on policy loans. If the policy terminates before repaying a loan, you may be taxed on the portion above the policy basis.
• Choose Tax-Advantaged Policies: Select life insurance policies that offer tax-advantaged cash value growth, such as whole life or universal life insurance.
• Avoid Overfunding MECs: Be cautious not to overfund your policy and trigger the conversion to a MEC, as this will change the tax treatment of withdrawals.

Taxation on dividends

Dividends on non-MEC policies are considered a return of premium and are generally not taxable. However, if the dividends are held in an interest-bearing account, the interest accrued is taxable as ordinary income. Additionally, if the dividends received exceed the premiums paid for the life insurance policy, the excess dividend amount is considered taxable income.

For MEC policies, dividends (except those used to purchase additional insurance or pay premiums on the same policy) are taxable when earned, to the extent of the gain in the contract. The gain is calculated as the difference between the cash value of the policy and the cost basis of the policy (premiums paid less any amounts received tax-free). If you surrender a MEC policy, the amount received may be taxable if it includes investment gains.

It is important to note that the taxation of dividends may vary depending on your specific circumstances and the type of life insurance policy you have. Please consult with a tax professional or financial advisor for personalized advice regarding the taxation of dividends on your life insurance policy.

Taxation on group term life insurance

Group term life insurance is a common part of employee benefit packages. Many employers provide a base amount of coverage, often at no cost, as well as the opportunity for the employee to purchase additional coverage through payroll deductions. The insurance plan may also offer employees the option to buy coverage for their spouses and children.

The first $50,000 of group term life insurance coverage is tax-free to the employee. According to the Internal Revenue Service (IRS) Code Section 79, the cost of any coverage over $50,000 that is paid for by an employer must be recognised as a taxable benefit and reported on the employee's W-2 form as income. The taxable amount is calculated using an IRS premium table, based on the employee's age, and is subject to Social Security and Medicare taxes.

If an employer differentiates—which is allowed, by offering different amounts of coverage to select groups of employees—then the first $50,000 of coverage may become a taxable benefit to them. This includes corporate officers, highly compensated individuals, or owners with a 5% or greater stake in the business.

If you are a beneficiary of a life insurance policy, the death benefit is not counted as taxable gross income. However, if the beneficiary chooses to delay the payout or take the payout in instalments, interest may accrue, and the interest paid to the beneficiary may be taxed.

Frequently asked questions