Life Insurance Tax Rules In Washington State

Life insurance is a contract between the policyholder and a life insurance company, where the company pays the policyholder's designated beneficiaries a sum of money upon their death. While life insurance benefits are typically not taxed, there are some circumstances when a payout can expose you to tax liability. This can include instances where the beneficiary is an estate, when the policy is surrendered, or when withdrawing money from the cash value of the policy. In Washington, the estate tax is currently the highest maximum estate tax in the country, with a tiered structure ranging from 10% to 20% on assets over $2,079,000. Additionally, Washington has implemented a long-term care payroll tax of 0.58% on employee wages to fund public long-term care benefits for residents. Understanding the taxation of life insurance in Washington is crucial for effective financial planning and ensuring that beneficiaries receive the intended benefits.

Naming your estate as your beneficiary

Firstly, if your estate is the beneficiary of your life insurance policy, the death benefit may be subject to estate taxes. In 2024, the federal estate tax ranges from 18% to 40%, depending on how much of the estate exceeds $13.61 million, the exclusion limit. This limit will revert to $5 million at the start of 2026 without congressional action. In addition to federal taxes, twelve states and the District of Columbia impose an estate tax, with exemption limits ranging from $1 million in Oregon to $13.61 million in Connecticut.

Secondly, naming your estate as your beneficiary could give creditors access to your life insurance death benefit, meaning your loved ones may receive less money. When the beneficiary is an individual, the death benefit is typically paid directly to them, bypassing probate court. However, when the estate is the beneficiary, the benefit becomes part of the probate process, where a judge determines what debts are owed. Creditors can then collect repayment from the estate before the remaining funds are dispersed according to the deceased's wishes.

Thirdly, naming your estate as the beneficiary may cause delays in the distribution of funds. The probate process can be lengthy and complicated, potentially taking years before your loved ones can access your assets.

Therefore, it is generally advisable to name specific individuals, such as your spouse or adult children, as your primary beneficiaries. This ensures that your loved ones can receive the financial protection you intended for them promptly and in full.

Withdrawing money from cash value

Withdrawing money from the cash value of a life insurance policy is a complex process with several factors to consider. Firstly, it's important to understand that not all life insurance policies allow withdrawals from their cash value. Traditional whole life policies and universal life policies, for example, may not permit such withdrawals.

If your policy does allow withdrawals, the amount you can withdraw may be limited, and there could be tax implications depending on the specifics of your policy and the amount you withdraw. Withdrawals up to the total premiums you've paid into the policy are typically tax-free, as you've already paid income tax on those premiums. However, if your withdrawal exceeds this amount, the excess may be taxed as income. It's important to note that your basis in the policy, which is used to calculate the taxable portion of the withdrawal, is the amount of premiums paid minus any prior dividends or previous withdrawals.

Additionally, it's worth considering the potential consequences of withdrawing money from your life insurance policy. Withdrawals that reduce the cash value of your policy could lead to a reduction in your death benefit, which may impact your beneficiaries. Withdrawing more than your basis in the policy during its early years could also result in unexpected tax consequences. Furthermore, withdrawals may cause your premiums to increase to maintain the same death benefit, or the policy could lapse if insufficient premiums are paid.

To avoid some of these issues, you could consider taking a policy loan from the insurance company, using the cash value in the policy as collateral. While this option may not be available for all policies, it can help you access your money without incurring surrender charges or immediate tax consequences. However, you will have to pay interest on the loan, which is generally not tax-deductible.

Surrendering the policy

Surrendering a life insurance policy means cancelling the policy and receiving its surrender value, which is the cash value minus any surrender fees. If you go down this route, the coverage ends, and your beneficiaries will not receive a death benefit when you pass away.

You will owe taxes on the amount you receive that is above the cost basis. The surrender value of a policy is based on the portion of premiums that went into the cash value account, plus the interest rate paid or investment gains. From that, outstanding loans are subtracted, along with any surrender fee. Surrender fees tend to decrease over time, so it is ideal to wait until the fee is minimal or non-existent. Also, the longer you've held the policy, the larger the cash value portion will likely be.

If your cash surrender value is worth more than you've paid in premiums, you will need to pay income taxes on the difference. It is important to remember that your beneficiaries won't receive a death benefit if you surrender your policy. So, when exploring your options for taking cash value from life insurance, consider how each method will impact your long-term estate planning and goals. There may be a better option if you need cash.

You can surrender part of the value in your policy while leaving the policy in force, or you can surrender the entire value and terminate the policy. If you surrender the 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. Some policies can levy surrender charges for many years after the policy is issued.

In addition, when you surrender your policy for cash, the gain on the policy is subject to income tax. Additional taxes could be incurred if you have an outstanding loan balance against the policy.

Although surrendering the policy can get you the cash you need, you're giving up the right to the death-benefit protection afforded by the insurance. If you want to replace the lost death benefit later, getting the same coverage might be more complicated or more expensive.

Employer-paid group life insurance

Group life insurance is a popular product in employee benefits packages. It is an easy and affordable way for employers to provide peace of mind for their employees. It is also a key part of any benefits package, and its affordability makes it even more attractive. Moreover, it alleviates the stress and financial burden on employers when an employee passes away.

Employer group life insurance plans typically have a Guaranteed Issue amount, meaning there is no health questionnaire to qualify for the plan. Employees will need to list a beneficiary, and they can change beneficiaries at any time. Employers usually offer a basic term group life insurance plan and allow the employee to purchase more coverage voluntarily. This additional premium would be automatically deducted from their paycheck, and they may also need to undergo a medical exam.

Employees usually don't have to pay anything for group life insurance, but opting for additional coverage will increase the premium. Individual life insurance is rather expensive, and employer group life insurance plans are more affordable, even if the employee wants additional coverage. The biggest downside for employees is that the policy is controlled by the employer. If they were to change jobs or if the employer decided to terminate the plan, the employee would no longer be covered.

If you are receiving proceeds from an employer-paid life insurance policy, any death benefit beyond $50,000 is taxed as income, according to the IRS.

Estate tax

In 2024, the federal estate tax ranges from 18% to 40%, depending on how much of the estate is over $13.61 million, the exclusion limit. Without congressional action, the limit will revert to $5 million (indexed for inflation) at the start of 2026.

In addition to federal tax, twelve states and the District of Columbia impose an estate tax, with the exemption limit ranging from $1 million in Oregon to $13.61 million in Connecticut. Washington is not one of these states.

There are ways to reduce the taxes on your estate and ensure your heirs benefit as much as possible. One way is to use life insurance death benefits. Estates can limit taxes (and sometimes avoid taxation) by transferring the ownership of life insurance policies, usually to an irrevocable life insurance trust (ILIT).

However, the three-year rule applies to such transfers. This means that gifts of life insurance policies made within three years of death are still subject to federal estate tax. Thus, if you die within three years of the transfer, the full amount of the proceeds is included in your estate and taxed accordingly.

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