Life Insurance And Taxes: What's The Deal?

Life insurance is a valuable tool for personal and business financial planning, as it enables the quick and easy transfer of assets upon death. In most cases, life insurance proceeds are not taxable, but there are some exceptions.

The death benefit paid out to beneficiaries is typically tax-free and not considered taxable income. However, if the beneficiary chooses to receive the payout in installments, any interest accrued will be subject to income tax. Additionally, if the policy is owned by a third party, the death benefit may be subject to gift tax.

Life insurance proceeds can also become part of the taxable estate if the beneficiary is not named in the policy. This can increase the value of the estate and potentially trigger estate taxes. To avoid this, it is recommended to choose a person as the beneficiary instead of naming the estate.

While life insurance premiums are generally not tax-deductible, there are some exceptions, such as when a business pays for an employee's life insurance policy. In this case, the premium payments may be tax-deductible as a business expense.

It is important to regularly review beneficiaries and policy details to avoid any unexpected tax complications. Consulting with a financial advisor or tax professional can help individuals make informed decisions and minimise potential tax liabilities.

When the payout is in installments

In most cases, life insurance payouts are not taxable. However, if you choose to receive the payout in installments, any interest that accrues on those payments will be taxed as regular income. The principal death benefit is still not taxed.

• Interest on installments: While the death benefit itself is typically not taxed, any interest that accumulates on installment payments will be subject to income tax. This means that your beneficiaries should be prepared to report and pay taxes on the interest portion of the payments they receive.
• Lump-sum vs. installment payments: Choosing between a lump-sum or installment payments depends on your financial situation and needs. Receiving a lump sum gives you immediate access to the full amount, while installments provide a steady income stream over time. However, the longer the payout period, the more interest may accrue, resulting in higher taxes.
• Tax planning: Consult a tax professional or financial advisor to understand the tax implications of receiving the payout in installments. They can help you estimate the potential tax burden and provide strategies to minimize taxes, such as investing the payout in tax-efficient options.
• Impact on beneficiaries: Consider the needs and preferences of your beneficiaries when deciding between a lump-sum or installment payments. While a lump sum provides immediate financial support, installments can offer a steady income stream for your beneficiaries, especially if they need long-term financial assistance.
• Alternative options: In some cases, you may have the option to leave the payout in an interest-bearing account with the insurance company. This can provide a higher return than traditional savings accounts, but the interest earned will be taxable. Alternatively, you can choose lifetime payments, which are based on your age and policy proceeds, and may result in a higher total payout if you live longer than expected.

When the payout is part of your estate

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. The payout could push your estate’s total taxable value over the limit, and your heirs would have to pay an estate tax on any assets above the threshold within nine months of your death.

In addition to federal estate taxes, some states levy their own estate or inheritance taxes. Exemption limits vary among states. For example, New York's estate tax kicks in after $6.94 million. Talk to a tax professional to learn how life insurance can affect estate taxes.

The bottom line? If you know your estate is worth less than $13.61 million, your loved ones won’t be hit with estate taxes. Plus, proceeds left to your spouse are typically exempt from estate tax, even if they exceed the federal limit.

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) and paying premiums out of the trust account. 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.

With ILITs, the rules are complex and must be followed to the letter. To prevent your policy from being brought back into the estate, it’s worth working with an advisor to set up the trust correctly. For example, the three-year rule states that a policy is still part of your estate if a transfer of ownership occurs within three years of your death.

The estate tax exemption is set to increase for inflation through 2025. In 2026, it will revert to a lower level—though Congress can adjust this at any time.

When the policy is owned by a third party

When a third party owns the policy, the beneficiary may be taxed. For example, if a mother buys her daughter a life insurance policy but names the father as the beneficiary, the father would be taxed. This is because the main parties involved in determining if a life insurance premium is taxable are the policy owner, the beneficiary, and the insured person. Usually, the policy owner and the insured person are the same, so the policy is not taxable. However, if a third person is involved, the beneficiary of the life insurance policy may be taxed.

In this scenario, it is essential to choose the beneficiary wisely. One common mistake is to make the beneficiary "payable to my estate." This can increase the value of the estate above the tax threshold, making taxes more likely. Instead, naming a person as the beneficiary makes it less likely that the policy will be taxed.

Another way to avoid taxation in this situation is to name the beneficiary as an irrevocable life insurance trust (ILIT). This keeps the cash value separate from the estate value. The value of the life insurance policy can then be distributed among any beneficiaries listed in the trust, potentially shielding them from paying taxes on the life insurance.

When the policy is sold

When it comes to selling your life insurance policy, also known as a life settlement, you can expect to encounter some tax implications. Here are some detailed paragraphs explaining what you need to consider when selling your policy:

Taxation on Life Insurance Sales

If you sell your life insurance policy, you may be subject to income and capital gains taxes. The portion of the sale amount that is equal to what you've paid in premiums (your "cost basis") is generally not taxed. However, if you sell the policy for more than its cash value, the excess amount is typically subject to income tax. Additionally, any amount you receive above the cash value may also be subject to capital gains tax. It's important to consult with a tax professional to understand the specific tax implications of selling your policy.

Life Settlements and Viatical Settlements

A viatical settlement is a specific type of life settlement available to terminally ill individuals. In this case, a third party purchases your life insurance policy for an amount less than the death benefit. The tax implications of a viatical settlement can be complex, and it's advisable to seek professional guidance. The taxation will depend on the difference between the sale price and the amount you've paid into the policy, as well as any profits made from the sale.

Partial Withdrawal vs Full Surrender

It's important to distinguish between a partial withdrawal and a full surrender of your life insurance policy. With a partial withdrawal, you can access the cash value of your policy without terminating it. The withdrawal amount may be limited, and any amount withdrawn up to your cost basis (total premiums paid) is typically tax-free. However, if you withdraw more than your cost basis, the excess amount may be subject to income tax. On the other hand, surrendering your policy means cancelling the coverage in exchange for the policy's cash surrender value. If the cash surrender value exceeds your cost basis, the difference will likely be taxed as ordinary income, which could push you into a higher tax bracket.

Tax Planning and Professional Advice

When considering selling your life insurance policy, it's crucial to carefully plan and seek professional advice. A qualified tax advisor can help you navigate the complex tax rules and regulations. Additionally, an estate planner can assist in minimising potential tax liabilities and ensuring your beneficiaries receive the maximum benefit. Regularly reviewing your policy and keeping it up-to-date is essential to avoid unexpected tax complications.

When the policy is surrendered

Surrendering your life insurance policy means cancelling the policy and receiving a payout. This payout is known as the cash surrender value. It is the cash value of the policy minus any surrender fees.

When you surrender a life insurance policy, you are agreeing to take the cash surrender value that the insurance company has assigned to your policy and, in return, forgo the death benefit. In other words, your beneficiaries will not receive a death benefit when you die.

There are a few important things to keep in mind when it comes to surrendering a life insurance policy:

Tax Implications

The cash surrender value of a life insurance policy is typically taxable. If you receive a payout that is greater than the amount you have paid in premiums, this excess amount will be taxed as ordinary income. Consult a tax professional to understand the specific tax implications for your situation.

Surrender Fees

Surrender fees vary depending on the age of the policy. Surrender charges can last about 10 to 15 years after purchasing the policy. Ideally, you would wait until the fee is minimal or non-existent before surrendering the policy.

Impact on Death Benefit

It is important to remember that surrendering your life insurance policy will result in the loss of the death benefit. This means that your beneficiaries will not receive a payout when you die. Consider the impact of surrendering the policy on your long-term estate planning and goals.

Alternatives to Surrendering

If you need access to cash from your life insurance policy, there are alternatives to surrendering it. You can borrow against the cash value of the policy or withdraw from the cash value while maintaining the policy. These options may allow you to access the cash you need without giving up the death benefit.

Timing

The timing of surrendering your life insurance policy can impact the cash surrender value you receive. Surrendering the policy earlier in the term may result in a lower cash surrender value since the cash value will be smaller, and you may owe surrender charges. Surrendering the policy later may result in a larger payout as the cash value will have had more time to grow.

Reasons for Surrendering

There are several reasons why someone might choose to surrender their life insurance policy. These include finding a better deal with a more affordable policy, no longer needing the coverage, or needing a large amount of cash quickly. It is important to carefully consider your financial goals and alternatives before making a decision.

Frequently asked questions