Aflac Life Insurance: Pre-Tax Benefits And More

Life insurance is a crucial financial safety net for individuals and families, providing peace of mind and financial protection in the event of a loved one's passing. While the topic of life insurance can be complex, understanding the tax implications is essential for beneficiaries. Aflac, a leading insurance provider, offers insights into the taxability of life insurance payouts, premiums, and investments. In most cases, life insurance payouts are not taxed, but there are exceptions, such as when the cash value of the policy exceeds a certain threshold, triggering estate or generation-skipping taxes. Additionally, the beneficiary's location may impact taxation, as certain states enforce inheritance taxes. Understanding these nuances is vital for beneficiaries to make informed decisions and effectively plan their financial future.

When is life insurance taxable?

In most cases, life insurance proceeds are not subject to income or estate taxes. However, there are some exceptions to this rule.

Firstly, if the policy's payout causes your estate's worth to exceed the IRS's estate tax threshold (in 2024, this was $13.61 million for an individual), your heirs might be charged estate taxes. If you die while holding a life insurance policy, the IRS will count the payout in the value of your estate, regardless of whether you name a beneficiary.

Secondly, if you are a beneficiary and you choose to receive the payout in installments, the interest that accumulates on the death benefit is subject to income tax. The original life insurance death benefit is typically exempt from this.

Thirdly, if you withdraw money from a cash value life insurance policy, you will be taxed on any amount that exceeds the policy basis (the sum of what you've paid in premiums, minus any dividends received).

Fourthly, if you sell your life insurance policy, you will be taxed on any cash value that exceeds the policy basis (income tax) and any other profits from the sale (capital gains tax).

Finally, if you surrender a life insurance policy, you will be taxed on the amount of the cash value that exceeds the policy basis.

Estate tax

The estate tax is a tax on your right to transfer property at your death. It is an accounting of everything you own or have certain interests in at the date of death. The fair market value of these items is used, not necessarily what you paid for them or their value when you acquired them. This total is your "Gross Estate". The property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests, and other assets.

Once the Gross Estate has been calculated, certain deductions (and in special circumstances, reductions to value) are allowed to arrive at your "Taxable Estate". These deductions may include mortgages and other debts, estate administration expenses, property that passes to surviving spouses, and qualified charities. The value of some operating business interests or farms may be reduced for estates that qualify.

The estate tax is a federal tax, but some states also impose their own estate taxes. The federal estate tax as of the 2024 tax year applies only to the value of an estate that exceeds $13.61 million. In 2025, the exemption rises to $13.66 million. Surviving spouses are exempt.

The federal estate tax is assessed on the estate's fair market value (FMV), not on the price the deceased paid. This means that any appreciation in the estate's assets over time will be taxed, but it protects those who inherit assets that have dropped in value. For example, if a house was bought for $5 million but its current market value is $4 million, the latter amount will be used for tax purposes.

Any part of the estate that is bequeathed to a surviving spouse is not counted in the total amount and isn't subject to estate tax. This is known as the unlimited marital deduction. When the surviving spouse who inherited the estate dies, the beneficiaries may then owe estate taxes if the estate's value exceeds the exclusion limit. Other deductions, including charitable donations or any debts or fees that come with the estate, are excluded from the final calculation.

State Estate Taxes

A dozen states impose their own estate taxes, all of which have lower threshold amounts than the federal estate tax. The lowest thresholds are $1 million. The highest estate tax rate is 18%. State estate taxes are levied by the state in which the deceased was living at the time of death.

Inheritance tax

It's important to note that the inheritance tax only comes into play if the cash value of the life insurance policy exceeds a certain amount. This is typically determined by each state's guidelines and regulations regarding taxes on life insurance policies.

To avoid paying inheritance tax on a life insurance payout, you can consider the following strategies:

• Choose your beneficiary wisely: Avoid making the beneficiary "payable to my estate," as this can increase the chances of being taxed. Instead, name a specific person as the beneficiary.
• Set up an irrevocable life insurance trust (ILIT): By setting up an ILIT, the trust owns the life insurance policy, and the proceeds are kept separate from your estate. This can help shield beneficiaries from paying taxes on the life insurance payout.
• Keep the cash value below the gift tax exemption: Ensure that the cash value of the life insurance policy does not exceed the gift tax exemption, which is $12.92 million or $17,000 per year as of 2023.

It's always recommended to consult with a tax professional to ensure you understand the tax implications of your life insurance policy and to explore ways to minimize your tax liability.

Income tax

If you sell your life insurance policy for cash, the life insurance payout can qualify for income tax if the profits are worth more than what you have paid so far. However, Viatical Settlements for the terminally ill can escape this tax.

If you surrender a life insurance policy, you will have to pay taxes on the life insurance cash value because it now falls under the income tax qualifications.

If the beneficiary isn't named in your policy, your life insurance benefits will go into a taxable estate. The first $11.7 million is not taxed at a federal level, but anything above this amount is subject to taxation. State regulations vary depending on location and have a lower chance of exemption.

Accident Insurance and Income Tax

The IRS doesn't allow you to deduct premiums you pay to maintain accident insurance coverage. However, the payout may be taxable if you have accident insurance through your employer and the employer pays for your coverage.

Critical Illness Insurance and Income Tax

The payout for critical illness insurance may be tax-deductible if the premiums for the plan are paid on a pre-tax basis.

Whole life insurance tax benefits

Life insurance is a way to provide financial security for your loved ones after you're gone. But did you know that it can also offer tax benefits? Here are some of the ways that whole life insurance can help you and your beneficiaries manage taxes:

Income-Tax-Free Death Benefit:

The death benefit from a whole life insurance policy is generally not subject to income tax. This means your beneficiaries will receive the full amount without having to pay taxes on it. This is a significant advantage over other financial accounts, such as retirement plans, where beneficiaries may face hefty tax bills.

Tax-Deferred Cash Value Accumulation:

Whole life insurance policies accumulate cash value over time, and this growth is tax-deferred. The cash value increases according to a schedule guaranteed by the insurance company and is not affected by market conditions. This tax-deferred growth allows your money to grow faster since it's not reduced by annual taxes.

Tax-Advantaged Access to Cash Value:

You can access the cash value of your whole life insurance policy through withdrawals or loans without immediate tax consequences. You can withdraw up to your premium payments (the "cost basis") tax-free. If you withdraw more than that, you may owe income tax on the gains above your premium payments. Alternatively, you can borrow against the cash value, and the loan is not treated as taxable income. However, the insurer will charge interest on the loan, and if the loan plus interest exceeds the cash value, you'll need to pay more into the policy or it may lapse.

Faster and More Certain Than Other Assets:

Life insurance payouts are generally quicker and more certain for beneficiaries than inheriting other assets, such as property. While property transfers may take months due to probate processes, life insurance payouts are typically received by beneficiaries within weeks, providing faster financial relief.

Irrevocable Life Insurance Trusts:

For individuals with a higher net worth, an irrevocable life insurance trust (ILIT) can be used to purchase the insurance policy. This excludes the policy from your personal estate, and the trust becomes the owner and beneficiary. When you pass away, your heirs won't have to pay estate or income taxes on the death benefits.

While whole life insurance offers these tax benefits, it's important to remember that tax regulations can be complex and vary based on your location. Consult a tax professional or financial advisor to understand how these benefits apply to your specific situation.

Frequently asked questions