Reporting Life Insurance: Tax Implications And Guidelines

Life insurance is often seen as a reliable way to provide for loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs, or securing their future. However, there are a few situations where taxes could come into play, and it's important to know when that might happen. For example, if your loved ones choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. That extra money from interest is considered taxable income, even though the original death benefit is not. Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate's total value is large enough, it may trigger estate taxes, reducing what your loved ones ultimately receive.

Interest on life insurance benefits

Life insurance payouts are generally not taxable, and beneficiaries usually receive them tax-free. However, interest on life insurance benefits is taxable and must be reported as such. This is the case even when the death benefit itself is not taxed.

If you choose to receive life insurance benefits in installments, any interest that accumulates on those payments will be taxed as regular income. The death benefit itself is typically not taxed in this scenario, but the interest will be. This is why it is generally recommended to choose a lump-sum payout, as it keeps the full death benefit tax-free.

If you are the beneficiary of a life insurance policy and receive payments in installments, you must report the interest as income on your taxes. This interest is calculated from the date of the insured person's death until the date the insurance company sends the final benefit check to the beneficiary. The insurance company will report this interest to the Internal Revenue Service (IRS).

It is important to note that there are different rules and considerations for various types of life insurance policies, such as term life insurance, whole life insurance, and universal life insurance. Additionally, specific situations, like surrendering a policy or receiving benefits from an employer-paid plan, may have different tax implications. Consulting a tax professional or financial advisor is always recommended to ensure compliance with tax laws and to optimize your tax benefits.

Estate taxes

The estate tax exemption amount is set by the Internal Revenue Code and is subject to change. For example, in 2022, the exemption amount was set at $12.06 million, while in 2023, it increased to $12.92 million. If the value of your estate, including the death benefit from your life insurance policy, exceeds this exemption amount, your estate will be taxed at a rate of 40%.

To reduce the impact of estate taxes on your beneficiaries, you can consider transferring the ownership of your life insurance policy to another person or entity. This strategy can help remove the life insurance proceeds from your taxable estate. However, it is important to note that the three-year rule applies to ownership transfers. This means that if you die within three years of transferring the policy, the proceeds will still be included in your estate and taxed accordingly.

Another option to mitigate estate taxes is to create an irrevocable life insurance trust (ILIT). By transferring the ownership of your life insurance policy to an ILIT, you can remove the proceeds from your taxable estate. It is important to note that you cannot be the trustee of the ILIT and you must give up any rights to revoke the trust. This ensures that the proceeds are not considered part of your estate for tax purposes.

In conclusion, while life insurance benefits are typically tax-free, they can impact the estate tax liability of your beneficiaries. By understanding the role of life insurance in estate tax calculations and utilizing strategies like ownership transfer or irrevocable life insurance trusts, you can better plan and ensure that your beneficiaries receive the maximum benefit.

Surrendering your policy

Surrendering your life insurance policy means you're cancelling it and no longer want or need it. This option typically applies to permanent life insurance policies, such as whole life or universal life insurance.

If you surrender your life insurance policy, you will receive a cash surrender value. This is based on the cash value of your policy, which is built up through regular premium payments. The cash surrender value will depend on the policy's duration, growth, and assets. Surrendering your policy earlier in the term may result in a lower cash surrender value, as the cash value will be smaller, and you may also have to pay surrender charges. If you surrender the policy later, you will likely receive a larger payout, as the cash value will be larger, and there will be fewer fees.

The cash surrender value of a life insurance policy can be taxable. If you receive more money than you paid in premiums, this excess may be taxed as regular income. Surrendering your policy may trigger tax consequences if any of the following occur:

• You receive more funds than the policy's cost basis.
• You have outstanding policy loans that exceed the policy's cost basis. The insurance company will deduct the loan amount and any interest from the cash surrender value. You'll then owe income tax on the lower surrender value if it exceeds the amount paid in premiums.

If you want to surrender your policy and receive the cash surrender value, you should first review your policy documents and speak with your insurer, who will guide you through their process for surrendering the policy and paying the cash surrender value. They will then provide you with the necessary paperwork, which you should fill out and provide all the information and documentation requested. After processing your surrender request and determining the proper cash surrender value based on the policy's terms, your insurer will pay you that amount, usually via check or direct deposit.

It's important to consult with a tax expert or financial advisor, as receiving a large payout could trigger unexpected tax consequences. They can help you report everything properly and advise you on where to allocate your funds.

Withdrawing or taking out a loan against your policy

If you have a life insurance policy with a cash value, you can withdraw limited amounts of cash from it. The amount available differs based on the type of policy and the company issuing it. Withdrawals are not taxable up to your policy basis, as long as your policy is not classified as a Modified Endowment Contract (MEC). An MEC is a life insurance policy in which the funding exceeds federal tax law limits.

If you take out a loan against your life insurance policy, you generally won't have to pay income taxes as long as the policy remains in force. However, you could potentially face a tax bill if you surrender your policy or if the policy lapses, and the amount you owe exceeds what you paid in. In that case, you would have to pay income tax on any earnings from the investment.

The money you borrow from a life insurance policy is not taxable, as long as it's equal to or less than the sum of the insurance premiums you have paid. However, life insurance companies add interest to the loan, and if you don't repay the interest charges, your policy could lapse.

If you surrender your policy or your policy lapses, you must pay taxes on the money that came from interest or investment gains, even if you have an outstanding loan.

If you withdraw or borrow more than the total amount of premiums paid into the policy, you will have to pay taxes on the excess amount.

Receiving death benefits as an annuity

When a person who has an annuity dies, the beneficiary—often a family member—will receive the remaining value of the annuity or a guaranteed minimum amount specified in the contract. This death benefit ensures that the invested funds are passed on to heirs, providing financial support.

Different annuities pay out to beneficiaries in different ways. Some annuities may pay the beneficiary steady payments after the contract holder’s death, while others may pay a death benefit as a lump sum. If the annuitant dies before the annuity begins, the beneficiary typically receives a lump sum. If they die after, they will usually continue receiving the annuity payments.

If the beneficiary is a spouse, they can change the annuity contract into their name, assuming all rules and rights to the initial agreement and delaying immediate tax consequences. They can collect all remaining payments and any death benefits and choose beneficiaries. The spouse then becomes the new annuitant.

If the beneficiary is not a spouse, they cannot change the annuity contract terms. A non-spouse can only access the designated funds from the annuity owner’s initial agreement.

If there is no named beneficiary, the annuity will become part of the estate and will be paid according to the will of the deceased. This involves a probate process, in which a deceased person's property is assessed and their will is verified before paying any outstanding taxes or debts and then distributing the remaining funds to beneficiaries. Probate fees can eat into the annuity benefit.

If the beneficiary is receiving the proceeds in instalments, this is known as a non-qualified "stretch". This can enable them to receive payments for the rest of their lives. However, the payments include proceeds and interest, which can be subject to taxes. The beneficiary must pay income tax on each withdrawal at the time they make it. If they take a lump sum payout, they pay taxes on that all at once, which could push them into a higher tax bracket. Regular periodic withdrawals spread out taxes over time.

Frequently asked questions