Life Insurance Rating: What You Need To Know

Life insurance is often tax-free, but there are exceptions. For example, if your beneficiaries choose to receive the life insurance payout in instalments instead of a lump sum, any interest that builds up on those payments could be taxed. This is because the original death benefit is not taxable income, but the interest is. Another exception is 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 beneficiaries receive.

Proceeds paid in a lump sum are generally tax-free

When a policyholder passes away, the proceeds, or death benefits, are paid to the named beneficiary or beneficiaries. In general, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income and is therefore not subject to income or estate taxes. This means that proceeds paid in a lump sum are generally tax-free.

However, there are some cases when a death benefit can be taxed. For example, if the payout is set up to be paid in multiple payments, the payments can be taxable. This is because an annuity is paid regularly over the life of the beneficiary and includes proceeds and interest. These payments can be subject to taxes.

Another instance where a death benefit can be taxed is if the beneficiary receives interest. Although the lump-sum proceeds of the life insurance policy typically aren't considered taxable income, any interest they earn would be, and funds that haven't been disbursed could accrue interest.

Additionally, if the money is paid to the insured's estate rather than a particular beneficiary, it could be taxable. For example, according to the IRS, if life insurance proceeds are included as part of the deceased's estate and together exceed the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. In 2023, this threshold was $12.92 million, and in 2024, estates over $13.61 million owe estate tax.

It's important to note that each state and insurer may have different policies and coverages, so it's always a good idea to consult with a tax professional or financial advisor regarding your individual situation.

Proceeds paid in installments can be taxable

Life insurance proceeds are generally not taxable as income. However, if the beneficiary receives the payout in installments, the insurer will typically pay interest on the outstanding death benefit. This interest is considered taxable income. Parents often opt for this payout structure if their beneficiary is a young child or someone dependent on their income.

The interest on installments is taxed as regular income, and beneficiaries should be prepared to report the interest on their taxes. The death benefit itself is not taxed.

There are a few other instances where taxes could be incurred on life insurance proceeds. For example, if the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, estate taxes may be triggered. This only occurs if the estate's total value exceeds the federal estate tax exemption. In 2023, this exemption was $12.92 million, and in 2024, it was $13.61 million.

Another scenario where taxes could be incurred is if the policyholder has withdrawn money or taken out a loan against the policy. If the money withdrawn or loaned is more than the total amount of premiums paid, the excess may be taxable.

It is important to carefully review the details of your life insurance policy and understand the potential tax implications to avoid any unexpected tax burdens.

Surrendering a policy can result in tax on excess cash value

Surrendering a life insurance policy means that you're terminating the policy. You don't want or need it anymore, or perhaps you want the cash value built up in the contract.

Surrendering a life insurance policy may trigger tax consequences, but this doesn't happen in every case. The Internal Revenue Service (IRS) considers the surrender of a life insurance policy a taxable event if the surrender value is more than the premiums you've paid.

The cash surrender value of a life insurance plan is the amount you'll receive if you surrender your policy to your insurer. This amount is based on your cash value, the component of a permanent life insurance policy that can help you build cash value through regular premium payments.

If you surrender your policy, you may receive more funds than the policy's cost basis. In this case, any amount you receive over the policy's basis (the amount you paid in premiums) can be taxed as income.

If 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 surrender your policy during the early years of ownership, when the value is relatively low, the company will likely charge surrender fees, reducing your cash value. These charges vary depending on how long you've had the policy and, often, on the amount being surrendered.

Before surrendering your policy, it's important to consult with a tax expert and financial advisor. They can help you understand the potential tax implications and explore alternative options, such as borrowing against your policy or selling your policy.

Proceeds may be taxed if the policy is included in the estate

When it comes to life insurance, it's important to understand the implications of taxes, especially when it comes to your estate. Here are some key points to consider:

Ownership and Beneficiaries

One crucial aspect to avoid taxation is to ensure that your estate is not designated as the beneficiary of your life insurance policy. By naming a specific person as the beneficiary, you can avoid the probate process and the potential for higher estate taxes. However, if the proceeds of the policy are payable to your estate, either directly or indirectly, they will be included in your gross estate for tax purposes.

Incidents of Ownership

Even if someone else is the legal owner of your life insurance policy, certain "incidents of ownership" can cause the proceeds to be taxed as part of your estate. These rights include the ability to change beneficiaries, assign or revoke the policy, pledge it as loan security, borrow against its cash surrender value, or surrender/cancel the policy. If you retain any of these rights, the proceeds will be considered part of your estate, regardless of who the beneficiary is.

Three-Year Rule

The IRS has a three-year rule that applies to transfers of ownership and the establishment of irrevocable life insurance trusts (ILITs). If you transfer ownership of your policy or set up an ILIT, and then pass away within three years, the proceeds will still be included in your estate and taxed accordingly. This rule helps determine who owns the policy and ensures that any transfers made shortly before death do not avoid estate taxes.

Using Trusts

One effective way to keep life insurance proceeds from being taxed in your estate is to set up an ILIT. By transferring the policy to the trust, along with assets to pay future premiums, you can remove yourself as the owner. This ensures that the proceeds are not included in your estate. Trusts offer more control over the policy and guarantee prompt payment of premiums.

Gift Tax Exclusion

When transferring ownership of a life insurance policy, it's important to be mindful of the gift tax exclusion. If the current cash value of the policy exceeds the annual gift tax exclusion amount ($16,000 in 2022 and $17,000 in 2023), gift taxes will be assessed and due at the time of the policyholder's death. This can complicate the process of avoiding estate taxes.

Whole life policies can be taxed if the withdrawal exceeds the premium paid

Whole life insurance policies are a form of permanent life insurance that provides coverage for your entire life, as long as you keep up with your payments. It also has a cash value component that allows you to withdraw or borrow money during your lifetime. However, it's important to understand the tax implications associated with these withdrawals or loans.

When you withdraw money from your whole life insurance policy, it's generally not taxable up to your policy basis. The policy basis refers to the total amount of premiums you've paid into the policy. If your withdrawal exceeds the total amount of premiums paid, the excess amount may be subject to taxation. This is because any gains on the policy, such as dividends or interest, are considered taxable income. Therefore, if your withdrawal exceeds the premium paid, the portion of the withdrawal that comes from these gains will be taxed.

Additionally, if your policy is classified as a Modified Endowment Contract (MEC), the tax treatment is different. In this case, withdrawals are taxed according to the rules for annuities. The money disbursed is considered to be taken from interest first and is subject to income tax. If the policy owner is under a certain age, there may also be an early withdrawal penalty.

It's important to note that withdrawals can have other consequences beyond taxation. Withdrawing money from your policy reduces the cash value and, consequently, may lead to a reduction in your death benefit. This could impact the financial security of your beneficiaries, who may rely on this money for income replacement, business purposes, or wealth preservation.

To avoid unexpected taxation and maintain the intended death benefit for your beneficiaries, it's crucial to carefully review the terms of your whole life insurance policy and consult with a tax professional or financial advisor. They can guide you in structuring withdrawals properly and minimizing tax liabilities.

Frequently asked questions