Life Insurance And Taxes: What You Need To Know

Life insurance is a financial safety net that ensures your family will be provided for in the event of your passing. But what happens when taxes come into the picture? Do beneficiaries have to pay taxes on the death benefit they receive? And how does life insurance impact your overall tax liability?

In most cases, life insurance proceeds are not considered taxable income, so beneficiaries can receive the full amount without worrying about a tax bill. However, there are some situations where taxes may apply. For example, if the beneficiary chooses to receive the payout in installments, any interest accrued on those payments may be subject to income tax. Similarly, if the policy is owned by a third party, the death benefit could be subject to gift tax if certain conditions are met.

Additionally, the life insurance payout could become part of your estate, and if the total value exceeds certain thresholds, your heirs might have to pay estate taxes. To avoid this, you can set up an irrevocable life insurance trust (ILIT) and transfer ownership of the policy to the trust.

When it comes to permanent life insurance policies with a cash value component, the tax implications can be more complex. Withdrawing more than your cost basis or surrendering the policy may trigger income taxes on the gains. Taking out a loan against the policy is usually tax-free, but if the policy lapses with an outstanding loan, the unpaid loan amount exceeding your cost basis will be treated as taxable income.

While life insurance premiums are typically not tax-deductible, there are some exceptions. For instance, if you gift a life insurance policy to a charity and continue to pay the premiums, those payments may be considered charitable donations and may be tax-deductible.

Understanding how life insurance interacts with taxes can help ensure that your beneficiaries receive the full benefit and avoid unexpected tax complications.

Interest on death benefits

In New York, interest begins to accrue from the date of death of the insured, not from the date that the claim is fully filed with the life insurer.

If the death benefit from a term life insurance policy is paid out in installments rather than as a lump sum, it may come with a hidden tax surprise. The death benefit itself is typically not taxed, but any interest that accumulates on those installment payments will be taxed as regular income. If the payout is spread over time, your beneficiaries should be prepared to report the interest on their taxes.

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). This puts the policy and the disbursement of the payout under the trust's control, so it's excluded from the value of your estate.

Estate taxes

Life insurance death benefits are typically not taxed as income, but they can be subject to estate taxes. Here's how:

If the estate is named as the beneficiary of a life insurance policy, the death benefit is included in the estate and may be subject to federal and state estate taxes. This usually happens when no beneficiary is named or when the named beneficiary passes away before the insured.

The federal estate tax exemption was $12.92 million in 2023, and $13.61 million in 2024. If the total taxable value of an estate exceeds this amount, the IRS levies an estate tax. Twelve states and the District of Columbia also impose their own estate taxes, with much lower exemptions, as low as $1 million in Massachusetts and Oregon in 2021.

To avoid estate taxes, it's essential to name both primary and contingent beneficiaries and keep those selections up to date.

Another way to avoid estate taxes is to transfer ownership of the life insurance policy to an irrevocable life insurance trust (ILIT). The trust owns the policy, pays the premiums, and gives the death benefit to the beneficiaries upon the insured's death. By placing ownership of the policy with a trust, the death benefit is removed from the estate, reducing its value and potentially bringing it below the exemption level.

However, the three-year rule applies to ownership transfers. This rule states that gifts of life insurance policies made within three years of death are still subject to federal estate tax. Therefore, careful planning is necessary to avoid unintended tax consequences.

Modified endowment contracts

A modified endowment contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. Once the Internal Revenue Service (IRS) relabels your life insurance policy as an MEC, it loses the tax breaks for withdrawals and loans that you make from the policy. This permanent change can happen when you pay excess premiums in too short a period.

Permanent life insurance contracts in the US are granted generous tax advantages, but if you put too much cash into one, it loses its status as "insurance" and becomes an investment vehicle instead. The MEC limits for a policy will depend on its terms and death benefit amount. Your insurance company should warn you if a policy is about to become, or has become, an MEC.

The IRS uses a "seven-pay test" to determine MEC status. It looks at whether the premiums paid during the first seven years of the policy would exceed the amount for the policy to be paid up after seven years.

If your life insurance policy becomes an MEC, your life insurance coverage will not change. However, MECs can be taxed at 10% for early cash value withdrawals. That's different from cash value accounts, which do not have a penalty for withdrawals.

The IRS's seven-pay test determines these contribution limits. Your insurance company gives you a limit for how much money you can pay into your life insurance account each year. This limit depends on how much money it would take to pay out your policy over the next seven years.

Life insurance policyholders may want to overpay on their policy to boost the holdings in their cash value account and increase the amount they've invested. However, if you pay over the annual limit within the first seven years, you would fail the seven-pay test, and the IRS could convert your life insurance policy into an MEC.

MECs are taxed differently from life insurance policies. Unlike a standard life insurance contract, money withdrawn from an MEC comes first from your earnings and then your principal. These earnings are included in your taxable income. In addition, a policy loan is treated as a withdrawal, and the gains are taxable.

If you have an MEC, the taxable portion of any withdrawals taken before you turn 59½ are subject to an additional 10% early withdrawal penalty.

Pros and Cons of MECs

An MEC doesn't provide the same tax advantages as a standard life insurance contract, and most people might be better off avoiding them. However, they do provide some benefits.

Pros of a modified endowment contract

• A life insurance policy that becomes an MEC still leaves a tax-free benefit to your life insurance beneficiary or beneficiaries.
• You will also continue to get guaranteed returns with less volatility than the stock market.
• MECs still provide tax-deferred growth. If you don't plan on withdrawing from your policy, an MEC allows you to build a large cash balance on a tax-deferred basis.
• Your life insurance death benefit still isn't taxed.
• MECs allow for the tax-free shifting of assets to beneficiaries, without probate proceedings, upon the owner's death.
• MECs can function as an alternative or supplement to annuities in your retirement and estate planning.
• MECs offer a higher yield on low-risk funds than some alternatives.

Cons of a modified endowment contract

• You cannot convert a policy that becomes an MEC back into a standard life insurance policy.
• You'll pay a 10% tax penalty on cash value withdrawals before the age of 59.5.
• Cash value in the policy becomes less accessible.
• Borrowing may reduce the death benefit for heirs.

Surrendering a policy

Surrendering a life insurance policy means terminating the policy because you no longer want or need it. This option usually applies to permanent life insurance policies, such as whole life or universal life insurance, which accumulate cash value over time. This cash value is then factored into the surrender value.

When you surrender your policy, you are essentially cancelling it to get the cash surrender value. However, this is not the only way to get the cash surrender value. You could also consider a policy loan or a partial surrender.

Tax Consequences of Surrendering a Life Insurance Policy

If the cash surrender value of a life insurance policy is higher than the amount of premiums you have paid into the policy (your cost basis or policy basis), the excess amount will be subject to income tax. This is because the IRS considers the difference as taxable income. The amount of tax you will owe depends on your marginal tax rate for the year, or your income tax bracket.

How to Calculate the Taxable Amount

The taxable amount is the difference between the cash surrender value minus the total premiums paid. For example, if you have paid $50,000 in premiums and the cash surrender value is $70,000, the taxable gain when surrendering your policy would be $20,000. The percentage you will owe in taxes depends on your current tax bracket.

How Surrender Fees Affect the Taxable Amount

Surrender fees are charges that the insurance company deducts from your cash value if you surrender the policy before a specified number of years, usually around ten. These fees are typically on a sliding scale, reducing over time. For example, if your cash value is $70,000, you paid $50,000 in premiums, and your surrender fee is $5,000, the net surrender value would be $65,000. To calculate the taxable gain, you then subtract the premiums paid ($50,000), leaving you with a taxable gain of $15,000.

Treatment of Outstanding Loan Balance Upon Surrender

If you have an outstanding loan against your cash value, the insurance company will deduct the loan amount and any interest from the cash surrender value. The lower surrender value may also reduce the amount of taxable gain and, by extension, the amount of income tax you owe.

Should You Surrender Your Life Insurance Policy?

This decision depends on your financial goals and whether you need the cash. It is important to consider the tax consequences, as well as the cash surrender value, the cost of getting another life insurance policy, and your future financial goals.

Alternative Options

Instead of surrendering your life insurance policy, you could:

• Borrow against the policy from the cash value
• Consider reduced paid-up insurance to free yourself from paying premiums
• Sell the policy, often for more than the cash surrender value

Life insurance dividends

Insurers usually pay dividends annually, and they are separate from cash value earnings. Life insurance dividends are typically not taxable because the IRS considers them a return of premiums paid. However, there are a few exceptions:

• Dividends exceed total premiums paid: If you receive more in dividends than the total premiums you've paid into the policy, the excess may be taxable because it is considered income rather than a return of premium.
• Earning interest on dividends: If you leave your dividends in your policy to earn interest, this interest income may be taxable if it exceeds the amount you've paid in premiums.

Policyholders can choose to receive their dividends in several ways:

• Cash: Receiving dividends in cash can supplement your income, be used for a specific purpose, or be invested elsewhere.
• Future premium payments: Applying dividends to future premium payments can reduce the cost of coverage and ensure coverage isn't lost due to financial problems.
• Accumulating interest: Leaving dividends in the policy to accumulate interest allows the principal to grow faster, resulting in larger interest payments and quicker wealth accumulation.
• Paid-up additional life insurance: Using dividends to purchase paid-up life insurance increases coverage without raising premium payments.
• Reduced paid-up policy: Purchasing a reduced paid-up policy with dividends lowers coverage but eliminates the need for future premium payments.

Frequently asked questions