Understanding Tax On Life Insurance Capital Gains

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, if you decide to get rid of your policy through a life insurance settlement or by surrendering it to your insurer, you may face income and capital gains taxes.

Surrendering a life insurance policy

There are two main types of life insurance policies that accrue cash value: whole and universal policies. These policies are the most likely to be surrendered as the cash value can be used for other investments or necessities.

When you surrender a life insurance policy, you are agreeing to accept the cash surrender value assigned by the insurance company and forgo the death benefit. The cash surrender value is the amount you receive after any surrender fees are deducted from the policy's cash value.

There are a few things to consider when surrendering a life insurance policy:

• Age of the policy: If the policy is not very old, you may incur surrender fees, reducing the amount of cash received.
• Tax implications: The gain on the policy is taxed as income. It is important to consult a tax professional to understand the tax consequences before making any decisions.
• Loss of coverage: Surrendering the policy means you will no longer have life insurance coverage, which may impact your financial future.
• Alternatives: There are alternatives to surrendering the policy, such as borrowing against the cash value or withdrawing a portion of the cash value while maintaining the policy.

The process of surrendering a life insurance policy typically involves the following steps:

• Review the policy documents to understand the terms and conditions related to cash surrender value, surrender charges, and other relevant information.
• Contact the insurance company and inform them of your intention to surrender the policy. They will guide you through their specific process.
• Fill out the necessary paperwork, such as a policy termination or surrender request form.
• Receive the cash surrender value from the insurance company, which will be the policy's cash value minus any surrender fees.
• Consult with a tax expert and financial advisor to properly report the payout and determine the best use of the funds.

It is important to carefully consider the implications of surrendering a life insurance policy and seek professional advice to make an informed decision.

Life insurance proceeds as income

Life insurance proceeds are generally not considered taxable income. When the policyholder of a life insurance policy passes away, the proceeds or death benefits are paid to the named beneficiary or beneficiaries. This payout is typically not considered part of the beneficiary's gross income and is therefore not subject to income or estate taxes.

However, there are certain exceptions where life insurance proceeds can be taxed. Here are some scenarios in which life insurance proceeds may be considered taxable income:

• Payout structure: While life insurance proceeds paid in a lump sum are generally tax-free for the beneficiary, if the payout is structured as multiple payments, these payments may be subject to taxes. For example, if a beneficiary chooses to receive their payout as an annuity, the payments will include both proceeds and interest. The interest accrued in the annuity account is considered taxable income.
• Withdrawing or taking out a loan against the policy: Some life insurance policies, such as whole life insurance, allow policyholders to withdraw or borrow against the policy's cash value. If the amount withdrawn or loaned exceeds the total amount of premiums paid, the excess amount may be subject to income taxes.
• Surrendering or selling the policy: If a policyholder surrenders or cancels their life insurance policy, they may receive a cash payment. If the surrender proceeds exceed the cumulative premiums paid, the excess amount may be taxed as regular income. Similarly, if a policyholder sells their policy to a third party, and the sales proceeds exceed the cumulative premiums minus certain costs, the excess may be subject to income taxes.
• Employer-paid group life plan: In some cases, an employer-paid group life insurance plan that pays out more than a certain amount (e.g., $50,000) may be taxable according to the Internal Revenue Service (IRS).
• Estate taxes: If the life insurance policy is included as part of the deceased's estate, and the total value of the estate exceeds the federal estate tax threshold (which was $12.92 million in 2023 and $13.61 million in 2024), estate taxes must be paid on the amount that exceeds the limit. Some states also assess inheritance or estate taxes depending on the value of the estate and the location of the deceased's residence.

It is important to note that the taxation of life insurance proceeds can vary depending on the specific circumstances and the location of the policyholder and beneficiary. It is always recommended to consult with a tax professional or financial advisor to understand the tax implications of life insurance proceeds in your particular situation.

Life insurance and estate taxes

Life insurance proceeds are generally not considered part of the beneficiary's gross income and are therefore not subject to income or estate taxes. However, there are certain situations in which a death benefit can be taxed.

Payout Structure

Life insurance proceeds paid in a lump sum are generally received by the beneficiary tax-free. However, if the payout is set up to be paid in multiple payments, these payments may be subject to taxes. For example, an annuity paid regularly over the life of the beneficiary includes proceeds and interest, which can be taxed.

Policyholder Withdrawals or Loans

Some life insurance policies, such as whole life insurance, allow the policyholder to withdraw or take out a loan against the policy. If the amount withdrawn or loaned exceeds the total amount of premiums paid, the excess may be taxable.

Surrendering Your Policy

If you surrender your life insurance policy, the amount you paid into the policy (the cash basis) that you get back is usually considered a tax-free return of your principal. However, any funds over your policy's cash basis will be taxed as regular income.

Employer-Paid Group Life Plan

In some cases, an employer-paid group life plan that pays out more than $50,000 may be taxable, according to the Internal Revenue Service (IRS). Otherwise, the death benefit is typically paid to beneficiaries tax-free.

Estate Value Exceeds Limits

If the life insurance proceeds are included as part of the deceased's estate and the total value exceeds the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. As of 2023, the IRS exemption amount is above $12.92 million, with a top tax rate of 40%.

To avoid estate taxes on life insurance proceeds, you can transfer ownership of the policy to another person or entity, or set up an irrevocable life insurance trust (ILIT). However, if you die within three years of the transfer, the proceeds will be included in your estate and taxed accordingly.

Life insurance dividends

Dividends are not guaranteed and depend on the type of policy and when it was purchased. The amount of dividend is based on the company's investment returns, mortality, and expenses.

There are several options for how to use your life insurance dividends:

• Taking your dividends as cash
• Paying your premium with your life insurance dividend
• Accumulating dividends inside the policy
• Purchasing additional coverage

The taxation of dividends depends on whether the policy is classified as a Modified Endowment Contract (MEC). If the policy is not a MEC, dividends are considered a return of premium and are generally not taxable. If the policy is a MEC, dividends are taxable when earned to the extent of the gain in the contract.

Life insurance settlements

A life settlement is when you sell your existing life insurance policy to a third party—an individual or an entity—other than the company that issued the policy. This is also sometimes called a senior settlement. The policyholder (seller) receives an immediate payment from the third party offering the settlement, and the buyer agrees to pay any additional premiums that might be required for the duration of the policy. In exchange, the buyer will receive the death benefit when the insured person dies.

The amount you receive will depend on a range of factors, including your age, health, and policy terms and conditions. Such payments are generally more than the policy's cash surrender value (the amount you can collect if you cancel the policy before it matures or you die) and less than the net death benefit (the amount specified in the insurance policy minus any unpaid premiums and outstanding loan balances or other withdrawals).

Life insurance is regulated by state insurance commissioners, and variable life insurance products are also regulated at the national level by the Securities and Exchange Commission (SEC) and FINRA. While the majority of states regulate life settlements, and variable life settlements are securities transactions subject to federal securities laws and applicable FINRA rules, not all life settlement transactions are regulated. It is important to research the purchasers of life settlements to see if they are regulated and required to be licensed.

The purchasers of life settlements, sometimes called life settlement providers, are generally institutions that either hold the policies to maturity or resell them—or sell interests in multiple, bundled policies—to hedge funds or other investors. The New York State Department of Financial Services recommends consulting your professional financial advisor, attorney, or accountant to help decide if this is the most suitable arrangement for you.

If you are planning to sell your policy because you need funds to pay expenses, there may be other options available that will allow you to keep your policy in force for your beneficiaries. For example, you can take a policy loan up to the amount of the cash value, or you may be able to take out some of the cash value to meet your immediate needs. You should seek the advice of your insurance agent or another professional before using the cash value of your policy.

Frequently asked questions