Life Insurance And Federal Taxes: What's Exempt?

Life insurance payouts are usually tax-free, but there are some situations where they are taxable. For example, if your employer provides life insurance as a fringe benefit, the first $50,000 of group term life insurance coverage is excluded from taxable income. However, the cost of coverage exceeding this amount is generally included in the employee's gross income and is subject to federal income tax and Federal Insurance Contributions Act (FICA) taxes. Additionally, if you choose to receive the life insurance payout in installments, any interest earned on the principal amount is subject to income tax. Understanding the tax implications of life insurance is crucial for effective financial planning.

Group-term life insurance

Like any benefit, it's important to understand the tax implications of group-term life insurance. In general, anything that an employee receives from their employer as compensation, including fringe benefits such as life insurance, is included in the employee's gross income unless a specific Internal Revenue Code (Code) exclusion applies.

Code Section 79, also known as the IRC section 79, provides an exclusion for the first $50,000 of group-term life insurance coverage provided under a policy carried directly or indirectly by an employer. This means that there are no tax consequences if the total amount of coverage does not exceed $50,000. The exclusion applies to the cost of up to $50,000 of employer-provided group term life insurance coverage. The same amount can be excluded from the employee's wages for Social Security and Medicare taxes.

However, if the coverage exceeds $50,000, the imputed cost of coverage in excess of this amount must be included in the employee's income and is subject to Social Security and Medicare taxes. This is true even if the employees are paying the full cost they are charged. The cost of coverage must be determined using the IRS Premium Table, which outlines the cost per $1,000 of coverage per month based on the employee's age.

For example, let's say an employer provides $100,000 in group-term coverage to two employees, William and Charlotte, who are 26 and 57 years old, respectively. According to the IRS Premium Table, William's insurance costs $0.06 per $1,000 each month, while Charlotte's costs $0.43 per $1,000 each month due to her age. To determine the taxable income for each employee, we calculate the excess coverage over $50,000 ($50,000 / $1,000 = 50) and then multiply this by the cost per $1,000. In this case, William's annual taxable income for insurance is $36.00, while Charlotte's is $258.00.

It's important to note that group-term life insurance for an employee's spouse or dependents may also be exempt from taxes if the coverage amount does not exceed $2,000. This is considered a de minimis fringe benefit and is not taxable to the employee.

Employer-provided life insurance

Life insurance is a financial product that pays out a lump sum in the event of the insured's death, providing financial support to one's beneficiaries and heirs. The death benefit coverage remains in effect as long as the policyholder pays the insurance premiums. The premiums owed for a policy depend on the insured's age and health, the size of the death benefit, and whether the coverage is term or permanent.

When an employer provides life insurance as part of an overall compensation package, the Internal Revenue Service (IRS) considers it income, which means the employee is subject to taxes. However, these taxes only apply when the employer pays for more than $50,000 in life insurance coverage. The premium cost for the first $50,000 in coverage is exempt from taxation.

For example, if an employer provides an employee, for the duration of their employment, with $50,000 in life insurance coverage in addition to their salary, health benefits, and retirement savings plan, the employee doesn't have to pay taxes on the life insurance benefit because it does not exceed the threshold set by the IRS.

On the other hand, if an employer pays for a $100,000 life insurance policy, the employee must pay taxes on part of that amount. The taxable amount is based on IRS tables, regardless of the actual premium paid. The cost of group-term insurance must be determined under a table prepared by the IRS, even if the employer's actual cost is less than the cost figured under the table. The amount of taxable phantom income attributed to an older employee is often higher than the premium the employee would pay for comparable coverage under an individual-term policy.

If you decide that the tax cost is too high for the benefit you're getting in return, find out whether your employer has a "carve-out" plan or is willing to create one. The employer can continue to provide $50,000 of group-term insurance (since there's no tax cost for the first $50,000 of coverage) and then provide the employee with an individual policy for the balance of the coverage. Alternatively, the employer can give the employee the amount they would have spent for the excess coverage as a cash bonus that the employee can use to pay the premiums on an individual policy.

Life insurance beneficiaries

Firstly, if the death benefit is issued in installments, the interest that accumulates on the benefit is subject to income tax. Secondly, if the policy is owned by a third party, beneficiaries might have to pay taxes. Additionally, if the policy owner had a high net worth, the death benefit might be subject to estate tax if it pushes the total value of the estate over the exemption limit, which is $13.61 million for individuals as of 2024. In this case, heirs would have to pay an estate tax on any assets above the threshold within nine months of the policy owner's death.

It is important to note that if the policy owner has a will or trust in place and names their estate as the beneficiary, the life insurance payout can be used to pay estate taxes. However, if the policy owner chooses specific individuals as beneficiaries, they will typically receive the life insurance payout tax-free, and estate taxes will be paid from other assets.

Furthermore, if the policy owner is of high net worth, they can avoid having the life insurance death benefit counted as part of their estate by transferring ownership to an irrevocable life insurance trust (ILIT) and paying premiums from the trust account. This ensures that the policy and the disbursement of the payout are controlled by the trust and excluded from the value of the estate.

While life insurance proceeds are typically not taxable for beneficiaries, it is important to be aware of these exceptions to avoid any unexpected tax liabilities.

Modified endowment contracts

A modified endowment contract (MEC) is a type of life insurance policy that has been modified to include additional benefits, such as the ability to access the policy's cash value during the insured person's lifetime. While traditional endowment policies are typically exempt from federal income taxes, MECs are subject to different tax rules due to their added flexibility.

When an endowment policy is modified, it may lose some of its favourable tax treatment. In the context of federal taxes, the key distinction lies in how the cash value of the policy is treated. With a traditional endowment policy, the cash value growth is typically tax-free, and withdrawals up to the amount of premiums paid are not subject to taxes. However, with a MEC, any gains in the cash value may be subject to different tax rules.

The tax implications of MECs can be complex, and it's important to understand the specific rules that apply. Here are some key points to consider:

• Tax on Gains: The cash value growth within a MEC may be treated as taxable income. This means that when you take a withdrawal or loan from the policy, you could be subject to income tax on any gains above the amount of premiums you have paid into the policy.
• Surrender Charges: MECs may have surrender charges, which are fees incurred when you cancel or surrender the policy. These charges could be subject to taxes and penalties, depending on the specific contract terms.
• Policy Loans: Some MECs may allow loans against the policy's cash value. While these loans may not be taxable, they could have implications for the death benefit paid to beneficiaries. Review the policy terms carefully to understand the potential tax consequences of policy loans.
• Death Benefits: The death benefits paid to beneficiaries from a MEC are typically a focus of tax considerations. While they may be income-tax-free, if the policy has been in force long-term and accumulated significant gains, a portion of the death benefit could be taxable as "income in respect of a decedent" (IRD) for the beneficiary.
• Tax Reporting: Ensure you understand the tax reporting requirements for MECs. Any taxable distributions or withdrawals from the policy should be reported accurately on federal income tax returns to avoid penalties and interest charges.
• Compliance with Regulations: Stay informed about regulations pertaining to funding, distribution, and ownership of MECs. Non-compliance could result in adverse tax consequences.

In summary, modified endowment contracts offer enhanced flexibility compared to traditional endowment policies, but they come with more complex tax considerations. It is important to carefully review the terms of your policy and consult tax professionals to understand the specific tax implications of your MEC. Proper planning and compliance can help maximise the benefits of your life insurance policy while minimising potential tax burdens.

Estate tax exemption

Estate Taxes and Life Insurance:

Life insurance proceeds are generally not taxable as income, but they can be included in your taxable estate for estate tax purposes. This means that if the total value of your estate, including life insurance payouts, exceeds certain exemption thresholds, your beneficiaries may be subject to estate and inheritance taxes.

Federal Estate Tax Exemption:

The federal estate tax exemption amount is substantial. For 2023, the exemption is set at $12.92 million per individual. Estates valued below this threshold are not subject to federal estate taxes when the owner dies. However, if your estate exceeds this limit, considering strategies to reduce your estate tax liability, such as life insurance transfers, becomes essential.

Spousal Exemption:

If your spouse is the beneficiary of your life insurance policy, the payout is typically not taxed and will be passed on to them without incurring estate taxes. Spouses usually have an unlimited exemption regarding estate taxes.

Non-Spousal Beneficiaries:

If your beneficiary is anyone other than your spouse, such as a child or parent, the life insurance payout will generally be added to the value of your estate. If the total value exceeds the federal and state exemption thresholds, any amount over the exemption is subject to estate and inheritance taxes.

State Estate and Inheritance Taxes:

In addition to federal estate taxes, it's important to consider state-level taxes. Currently, 17 states, plus Washington, D.C., impose an inheritance or estate tax. The exemption amounts vary by state, ranging from $1 million to $7 million. The tax rates in these states can be as high as 20%, depending on the location.

Strategies to Avoid Estate Taxes:

To avoid estate taxes on life insurance proceeds, you can consider the following strategies:

• Irrevocable Life Insurance Trust (ILIT): By setting up an ILIT, you transfer ownership of the life insurance policy to the trust and give up all rights to revoke the trust or alter its terms. The policy benefits will then be excluded from your taxable estate.
• Ownership Transfer: Another option is to transfer ownership of your life insurance policy to another person or entity. This strategy requires choosing a competent adult or entity as the new owner, who will then be responsible for premium payments. It's important to obtain written confirmation from your insurance company to ensure a proper assignment.
• Maximize Gifting: You can gift up to $16,000 per person in 2022 ($17,000 for 2023) without incurring gift taxes. This can be utilized to help the recipient pay the premiums on the life insurance policy.
• Timing Considerations: Keep in mind the three-year rule when planning any ownership transfers. This rule states that gifts of life insurance policies made within three years of death are still subject to federal estate tax. Therefore, it's advisable to initiate any transfers well in advance to ensure that three years pass before your death, so the policy is not included in your taxable estate.

Frequently asked questions