Understanding Tax Implications Of Life Insurance Payouts

Life insurance payouts are usually tax-free, but there are some exceptions. If the death benefit is paid out in instalments and the remaining portion earns interest, that interest is taxable. A life insurance payout might also be taxable if it's paid to the insured's estate instead of an individual or entity. If you receive proceeds from an employer-paid life insurance policy, any death benefit beyond $50,000 is taxed as income, according to the IRS. If you are the policy holder who surrendered the life insurance policy for cash, and the amount you received is more than the cost of the policy, you may have to pay taxes on the difference.

Interest on the death benefit

Generally, life insurance proceeds received by a beneficiary due to the death of the insured person are not taxable and do not need to be reported as income. However, any interest accrued on the death benefit is taxable. This means that if the life insurance proceeds have accumulated interest, taxes are due on the amount that earned interest, rather than the entire death benefit.

According to the Internal Revenue Service (IRS), any interest received on life insurance proceeds is taxable and should be reported as interest received. The IRS further states that if the policy was transferred to the beneficiary for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. There may be exceptions to this rule.

In the state of New York, interest on the proceeds of a life insurance policy begins to accrue from the date of death of the insured and is computed daily, until the date of payment. The interest rate is determined by the rate in effect as of the date of death, which is subject to fluctuations and changes over time.

To avoid paying taxes on life insurance proceeds and interest, beneficiaries can consider strategies such as transferring ownership of the policy to another person or entity, or setting up an irrevocable life insurance trust (ILIT).

Payout to an estate

If you name your estate as the beneficiary of your life insurance policy, the person or people inheriting your estate may have to pay estate taxes. This is because the value of the life insurance proceeds will be included in your gross estate if the proceeds are payable to your estate, either directly or indirectly.

In 2024, the federal estate tax exemption limit is $13.61 million for an individual. This means that if you die in 2024 and the total taxable value of your assets is greater than this amount, the IRS will levy an estate tax. 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. But if you choose one or more 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 the 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. Talk to a tax professional to learn how life insurance can affect estate taxes.

The bottom line? If you know your estate is worth less than $13.61 million, your loved ones won't be hit with estate taxes. Plus, proceeds left to your spouse are typically exempt from estate tax, even if they exceed the federal limit.

Owner and insured are different

Typically, the owner and the insured of a life insurance policy are the same person. However, if a third person is involved, the beneficiary of the policy may be taxed. For example, if a mother buys her daughter a life insurance policy but names the father as the beneficiary, the father would be taxed.

In this case, the payout to the beneficiary could be considered a taxable gift. The IRS will treat it as though it still belongs to the original owner if transferred within three years of their death. Therefore, it is crucial to be aware of gift tax limits when considering an ownership transfer. The 2024 annual gift tax exemption is $18,000, and the lifetime exclusion amount is $13.61 million. Staying within these limits may help avoid taxation.

To avoid taxation on life insurance proceeds, you can transfer ownership of the policy to another person or entity. This strategy is particularly useful when an estate is involved, as the tax liability depends on the policy's ownership at the time of the insured's death. By transferring ownership, you can ensure that the proceeds are not included in your estate.

Another option is to create an irrevocable life insurance trust (ILIT). An ILIT owns the life insurance policy, and you can state how you want the beneficiaries to receive or use the payout. This option may shield beneficiaries from paying taxes on life insurance. However, it is important to remember that an ILIT cannot be revoked once established, and you cannot be the trustee of the trust.

Withdrawing from a cash value policy

Withdrawing from a cash value life insurance policy is generally tax-free up to your basis in the policy. Your basis is the amount of premium you have paid into the policy, minus any prior dividends paid or previous withdrawals. You have already paid income tax on those dollars, so they won't be taxed again when you withdraw them from the policy.

However, your policy's cash value consists of your basis in the policy, plus any earnings. Because the earnings grow tax-deferred while inside the policy, they will be subject to income tax when you withdraw them. This means that if you make a withdrawal over and above your basis in the policy, a portion of the withdrawal will be considered taxable income. Withdrawals are generally treated as coming out of your policy basis first.

For example, if you have a cash value life insurance policy with a cash value of $18,000 and a basis in the policy of $12,000, a withdrawal of $12,000 or less will have no income tax consequences. However, if you withdraw $15,000 from the policy, you will have to pay income tax on $3,000 of it (at ordinary income rates, not capital gains rates).

It is important to note that certain types of cash value life insurance policies (e.g. universal and traditional whole life policies) may not allow you to withdraw from your cash value at all. If your policy does allow withdrawals, be aware that surrender charges may apply even if you withdraw only up to your basis. To avoid this, you can take a policy loan from the insurance company, using the cash value in the policy as collateral. The amount you borrow is generally not treated as taxable income as long as you repay the loan, and there are no surrender charges because you are not actually withdrawing your money. However, you will have to pay interest on the loan, which is not tax-deductible.

Surrendering a policy

Surrendering a life insurance policy means cancelling it and receiving a payout from your insurer. This payout is known as the cash surrender value, which is the money a policyholder receives for ending their coverage, minus any surrender fees and taxes on earnings.

The cash surrender value is different from the policy's cash value, which is the total sum in the savings component of permanent policies like whole and universal life insurance. The cash surrender value is lower than the cash value due to surrender fees, which typically range from 10-35%. Surrender fees are usually highest in the early years of the policy and then gradually decrease over time. Most policies also have a waiting period of at least 15 years before you have the option to surrender.

When you surrender a policy, you'll lose coverage and no longer be responsible for paying insurance premiums. However, you may have to pay surrender fees for cancelling your coverage early, which will be deducted from any cash value your policy has or paid out of pocket if you have a term policy. You may also have to pay taxes on the surrender value if earnings exceed the amount you've paid into the policy.

For example, if you've paid $20,000 in premiums but your policy has a cash value of $30,000, you'll need to pay taxes on the $10,000 in earnings. The amount of tax you'll pay depends on your income bracket. Assuming a rate of 22%, you'd pay $2,200 in tax, leaving you with a cash surrender value of $27,200 before fees. If surrender fees are 20%, this would be a further $5,440 deduction, leaving a final cash surrender value of $21,760.

There are several reasons why someone might choose to surrender a policy, including no longer needing coverage, the cost of premiums, finding a better policy, or needing cash. However, it's important to consider the pros and cons of surrendering a policy. While it's easy and fast, and will get you some money back, there is a minimal return, and you'll have to pay surrender fees.

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