Life Insurance Annuity Interest: Taxable Or Not?

Life insurance and annuities are both insurance products that allow individuals to invest on a tax-deferred basis. While life insurance is primarily used to pay your beneficiaries when you pass away, an annuity grows your savings and pays you an income while you are still alive. However, there is an option to set up a death benefit on an annuity contract, where your heir will receive a payout based on the contract terms and your balance.

In terms of taxation, the death benefit paid out to beneficiaries from life insurance is typically not subject to federal income tax. On the other hand, the interest accrued on the death benefit is subject to income tax. Similarly, for annuities, the principal is generally not taxable, but the interest and earnings are subject to income tax.

Interest on death benefits is taxable

If the beneficiary receives the death benefit in installments that include interest, then the interest is taxable. This is because the interest is considered income by the IRS. Funds that remain in the account and have not been disbursed could also accrue interest over time. This is the case for specific income payouts, where the insurer places the benefit proceeds into an interest-bearing account and makes regular payments to the beneficiary. The interest on such a payout option is taxable.

Similarly, retained asset accounts, where the insurance payout is placed in an interest-bearing account and the beneficiary can withdraw funds as needed, also accrue taxable interest. Lifetime or fixed-period annuities, where the death benefit is paid out in installments over the beneficiary's lifetime, may also accrue interest that is taxable.

If the death benefit is paid to the insured's estate instead of an individual or entity, it could also be taxable. In 2024, estates over $13.61 million owe estate tax. Additionally, if the owner of the policy is not the same as the insured, the payout to the beneficiary could be considered a taxable gift.

Withdrawing from a non-qualified annuity before 59

Withdrawing from a non-qualified annuity before the age of 59½ will result in a 10% early withdrawal penalty in most cases. This is because non-qualified annuities are funded with after-tax dollars, so only the earnings on your investment are taxable. There is no legal age requirement for withdrawing from a non-qualified annuity, but if you withdraw before you are 59½, you will likely have to pay the penalty.

The IRS differentiates between non-qualified and qualified annuity withdrawals in terms of taxation. For non-qualified annuities, only the earnings portion is taxed. In contrast, for qualified annuities, all money withdrawn is taxed as regular income.

If you purchased your non-qualified annuity after August 13, 1982, your distributions will follow the "last-in-first-out" protocol of the IRS. This means that any money you withdraw from your annuity is assumed to be taken first from the contract's accumulated earnings. So, non-qualified annuity withdrawals are taxed as income until the withdrawal amount exceeds the annuity's growth.

It's important to note that annuities are a type of insurance contract designed to turn your money into future income payments. You can set up the annuity with a growth period where it builds your savings, and the return depends on the type of annuity you choose. Annuities can be a good addition to your retirement plan, but it's crucial to consider the tax implications of withdrawing from them early.

Surrendering a life insurance policy

Different types of policies have varying outcomes when it comes to surrendering. Whole and universal policies accrue cash value, making them the most likely option for surrender. Depending on the type and age of the policy, they may have accrued a significant amount of cash value or very little. Surrendering a policy can rid you of the burden of a monthly premium and potentially net a fair amount of money for other investments or necessities.

There are a few things to keep in mind when considering surrendering a life insurance policy. First, if your policy isn't very old, you may incur surrender fees, which will lessen the amount of cash you receive. Second, the gain on your policy will be taxed as income. Death benefits are tax-exempt, but the cash received from surrendering a policy is taxable. It is important to consult a tax professional before making any decisions.

To surrender a life insurance policy, you will need to gather your policy documents, including the contract, amendments, and payment receipts. You will then need to notify your life insurance provider that you would like to surrender your policy. The insurer will guide you through their process, which will typically include paperwork such as termination and surrender forms. The insurer will review the paperwork and may take anywhere from 7 to 30 business days to process the request.

Once the surrender request has been approved, the insurer will pay you the cash surrender value through a check or direct deposit. The amount you receive will be the cash surrender value minus any surrender fees and outstanding debts if you had a loan on the policy. You may also have to pay income taxes on the proceeds if your payout exceeds the premiums you paid.

There are pros and cons to surrendering a life insurance policy. On the one hand, it is a simple and quick process, and you will get some money back. On the other hand, you will only get one offer from the insurance company, and there may be surrender fees and tax implications.

According to the Internal Revenue Service, any interest received from life insurance proceeds is generally taxable and should be reported as interest received. If the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. There may be exceptions to this rule, and you should consult the relevant IRS publications for more information.

Qualified vs non-qualified annuities

When saving for retirement, annuities can be an integral part of your financial strategy. They provide a reliable income stream in your later years. When you buy an annuity, you set up a contract with an insurance company where you pay either a lump sum or premiums over time.

One factor to consider is investing in a qualified vs. non-qualified annuity. They differ in how you fund them and when you pay taxes, which play a role in the overall tax efficiency of your retirement strategy.

A qualified annuity is a retirement savings plan funded with pre-tax dollars. Contributions are deducted from an investor's gross income, and taxes are deferred until retirement, when the investor starts making withdrawals. Qualified annuities are often set up by employers as part of a company-sponsored retirement plan, such as a 401(k) or 403(b) plan. They have annual contribution limits set by the IRS.

Non-qualified annuities, on the other hand, are funded with post-tax dollars. Taxes on the contributions have already been paid, so there is no immediate tax benefit. Non-qualified annuities have no IRS-imposed contribution limits, but the insurance company offering the annuity may set limits.

Key Differences:

The main differences between qualified and non-qualified annuities lie in their tax treatment, contribution limits, distribution rules, and early withdrawal penalties.

Qualified annuities offer an immediate tax advantage by reducing taxable income in the contribution year, whereas non-qualified annuities do not provide this benefit. However, with non-qualified annuities, you only pay taxes on the earnings at withdrawal, not the principal.

Qualified annuities have annual contribution caps set by the IRS, while non-qualified annuities do not.

Qualified annuities have required minimum distributions starting at age 73, whereas non-qualified annuities do not, allowing more control over when you access your funds.

With qualified annuities, any withdrawals made before age 59½ may incur a 10% federal tax penalty, in addition to regular income taxes. Non-qualified annuities also have a 10% early withdrawal penalty, but only on the earnings, not the principal.

Choosing between a qualified and non-qualified annuity depends on your financial circumstances and goals. Qualified annuities offer upfront tax advantages but come with more restrictions, while non-qualified annuities provide more flexibility and a potentially lower tax burden in retirement.

Estate taxes

• Estate Threshold: Federal and state laws in the United States set thresholds or exemption limits for estate taxes. As of 2024, the federal estate tax threshold is $13.61 million. This means that estates valued above this amount may be subject to estate taxes. It's important to stay updated with the applicable laws, as these thresholds can change over time.
• Naming Beneficiaries: If a life insurance policy does not have any named beneficiaries, the proceeds may be included in the deceased's estate. In such cases, if the total value of the estate, including the life insurance proceeds, exceeds the federal or state estate tax threshold, estate taxes will need to be paid on the excess amount.
• Impact of Interest: When a life insurance benefit is paid out as an annuity or in installments, the interest accrued on the unpaid portion can be subject to income tax. This interest income may also contribute to the overall value of the estate, potentially pushing it above the estate tax threshold and triggering additional tax liabilities.
• Transfer of Ownership: To avoid estate taxes, individuals can transfer ownership of their life insurance policy to another person or entity. This strategy should be approached carefully, as there are specific guidelines and regulations to follow. Seeking professional tax advice is essential to ensure compliance with applicable laws.
• Irrevocable Life Insurance Trust (ILIT): Another strategy to mitigate estate taxes is to establish an ILIT. By transferring ownership of the life insurance policy to an ILIT, the proceeds are effectively removed from the taxable estate. It's important to note that establishing an ILIT is an irrevocable decision, and the individual establishing the trust cannot be the trustee.
• Regular Reviews and Planning: It is recommended to periodically review your life insurance policy and estate plan, especially in light of changing tax laws. Consulting with tax professionals can help identify strategies to minimize tax implications and ensure compliance with applicable regulations.

Frequently asked questions