Government Life Insurance: Taxable Or Not?

Life insurance is a way to provide for your loved ones after you're gone, and one of its advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses. However, there are some situations where taxes could come into play, and it's important to be aware of these to avoid burdening your beneficiaries with unexpected tax bills.

• Estate taxes if the proceeds are included in the estate and above the tax exemption amount
• Inheritance taxes in certain states
• Withdrawing money from the cash value of the policy
• Surrendering the policy
• Employer-paid group life insurance
• Payment in installments |

Interest on installments

While life insurance proceeds are generally not taxable, the interest accrued on them is taxable. If the beneficiary of a life insurance policy chooses to receive the benefit in installments, the benefit is placed into an account that can accrue interest. While the beneficiary will not pay taxes on the benefit itself, they will be responsible for paying income taxes on any interest accrued. For example, if a beneficiary receives a $500,000 death benefit that earns 10% interest for one year before being paid out, they will owe income taxes on the $50,000 in interest growth.

The death benefit from a term life insurance policy paid out in installments may come with a hidden tax surprise. The death benefit itself is typically not taxed, but any interest that accumulates on those installment payments will be taxed as regular income. If the payout is spread over time, your beneficiaries should be prepared to report the interest on their taxes.

The IRS considers any interest you receive on life insurance proceeds as taxable, and you should report it as interest received. If you receive proceeds from an employer-paid life insurance policy, any death benefit beyond $50,000 is taxed as income.

When receiving life insurance proceeds, it is important to consider the potential tax implications, especially if you choose to receive the benefit in installments. By understanding the tax treatment of life insurance proceeds, you can make informed decisions and avoid unexpected tax liabilities.

Estate taxes

Life insurance payouts are generally not subject to income taxes or estate taxes. However, there are some exceptions to this rule. The type of policy, the size of the estate, and the structure of the payout can determine whether or not life insurance proceeds are taxable.

If the value of the estate, including the life insurance proceeds, exceeds the federal estate tax threshold, estate taxes must be paid on the amount over the limit. As of 2023, the federal estate tax threshold was $12.92 million, and in 2024, it was $13.61 million. Some states also assess inheritance or estate taxes, depending on the estate's value and the location of the deceased.

To avoid estate taxes, it is important to ensure that the estate is not designated as the beneficiary of the policy. Additionally, the policyholder should avoid retaining certain economic ownership rights, known as "incidents of ownership," in the policy within three years of their death. These rights include the ability to change beneficiaries, assign or revoke the policy, pledge the policy as loan security, borrow against the policy's cash surrender value, and surrender or cancel the policy.

One way to avoid estate taxes is to set up an irrevocable life insurance trust (ILIT), which keeps the life insurance proceeds from being taxed as part of the insured's estate. The policy is transferred to the trust, along with assets to pay future premiums, or the trust purchases the insurance itself. As long as the trust agreement does not give the insured any of the ownership rights mentioned above, the proceeds will not be included in the estate.

It is also important to note that if the beneficiary of a life insurance policy is not named, the benefits will typically go into a taxable estate. To avoid this, it is recommended to choose a person as the beneficiary instead of designating the payout as "payable to my estate," which can increase the chances of taxation.

Inheritance tax

In most cases, life insurance proceeds are not taxable. However, there are certain scenarios where the beneficiary may be taxed. One such scenario is inheritance tax. Inheritance tax is a tax placed on the recipient for any inherited cash payouts, properties, and other assets. Currently, Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are the only states that enforce this tax.

If you live in one of the aforementioned six states, you may be subject to inheritance tax. Each state has its own set of guidelines regarding taxes on life insurance policies. To determine if your life insurance payout is subject to inheritance tax, it is advisable to consult a tax professional. They can provide guidance on your specific situation and help you understand the applicable state regulations.

It is important to note that, in general, life insurance proceeds are not considered taxable income. However, if the payout is particularly large, the cash value of the life insurance policy may be taxable. Additionally, if the policyholder elects to delay the benefit payout, resulting in interest accumulation, the beneficiary may be taxed on the interest generated during that period.

To avoid potential inheritance tax, careful consideration should be given to the selection of beneficiaries. Designating the beneficiary as "payable to my estate" can increase the value of the estate, making it more likely to exceed the tax threshold. Instead, naming a specific person as the beneficiary may reduce the likelihood of being taxed.

Policy riders

• Jewelry insurance coverage: If you have valuable jewelry that exceeds the sublimits of your homeowner's insurance policy, you can add a jewelry rider to protect those items.
• Water backup coverage: This rider covers water damage from backed-up drains, sewage, or sump pump issues, which may not be included in standard homeowner's policies.
• Extended replacement cost coverage: This rider helps cover the increased costs of rebuilding your home after a localized disaster, which may exceed the limits of your policy.
• Building ordinance or law coverage: Also known as building code coverage, this rider helps pay for the increased costs of repairing or rebuilding your home due to updated building codes.
• Service line coverage: This rider covers problems with pipes outside your home, such as in your yard or elsewhere on your property.
• Errors and omissions insurance: This rider protects businesses against negligence claims for work performed before purchasing insurance.
• Commercial property insurance: If your business involves moving equipment or other valuable items from place to place, adding a floater rider ensures protection against theft or damage during transit.
• Workers' compensation insurance rider: This rider extends coverage to include independent contractors for job-related injuries or illnesses, which are usually not covered in standard workers' compensation insurance.

Gift taxes

The annual gift exclusion applies per recipient, meaning you can give $19,000 to multiple people without incurring gift taxes. Additionally, gifts to qualified nonprofits are considered charitable donations rather than gifts.

There is also a lifetime gift tax exclusion, which is currently set at $13.99 million for an individual and $27.98 million for married couples filing jointly. This means you can give more than the annual limit to one person without paying gift taxes, as long as it stays within your lifetime exclusion limit. However, this exclusion also counts towards your estate tax, which can impact your estate planning.

The gift tax rate ranges from 18% to 40% and is typically only paid on amounts that exceed the lifetime exclusion. While few people end up owing gift taxes due to the high exclusion amounts, it's important to consider state-specific rules, as some states have lower limits for lifetime exclusions.

Frequently asked questions