Life Insurance Tax Laws In Texas: What You Need To Know

Life insurance is often seen as a reliable way to provide for loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. In most cases, life insurance proceeds are not considered taxable income, but there are some exceptions to be aware of.

The primary purpose of life insurance is to provide a death benefit that can take care of your loved ones financially. Life insurance death benefits aren't typically taxed, so beneficiaries receive the money without a tax burden. Since coverage amounts can be very high—into the millions—it's a significant advantage that the life insurance payout is tax-free.

However, there are certain situations where a life insurance death benefit may be taxable. For example, if the beneficiary chooses to delay the payout or take the payout in instalments, interest may accrue, which may be taxed. Additionally, if a beneficiary is not named, or is deceased, the life insurance death benefit goes into the estate of the insured person and can be taxable along with the rest of the estate.

In Texas, proceeds from a life insurance policy can be taxable in certain cases. For instance, if the beneficiary decides to take life insurance payouts in instalments, the interest received from the insurance company will be considered income and thereby taxed.

Interest on life insurance payouts

In most cases, life insurance proceeds are not considered taxable income. However, there are some exceptions to be aware of. One such exception is when interest accrues on the payout. This typically happens when the beneficiary chooses to delay the payout or take the payout in installments. In this case, the interest paid to the beneficiary may be taxed.

The IRS considers any interest received by the beneficiary on a life insurance payout to be taxable income. This is because the interest is seen as generating income for the beneficiary, which has not been previously taxed. Therefore, it is important for beneficiaries to report this interest on their taxes.

To avoid this tax implication, beneficiaries can choose to receive the life insurance payout as a lump sum. This option ensures that the death benefit remains tax-free. However, if the beneficiary chooses to receive the payout in installments, it is important to be aware of the tax implications and plan accordingly.

It is also important to note that the tax laws regarding life insurance can be complex and may vary depending on the specific circumstances. Therefore, it is always recommended to consult with a tax professional to understand the tax status of any life insurance payout.

In addition to the interest on life insurance payouts, there are other situations where taxes could impact the proceeds. For example, if the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, estate taxes may apply. Working with an estate planner can help minimize these tax implications and ensure that loved ones receive as much of the death benefit as possible.

Furthermore, permanent life insurance policies, such as whole or universal life, have their own tax rules. Policyholders can generally borrow or withdraw money from the policy's cash value without immediate tax consequences. However, if there are unpaid loans against the policy, they will be deducted from the death benefit, resulting in a lower payout for the beneficiaries.

In conclusion, while life insurance proceeds are generally tax-free, there are certain situations where taxes may apply. Interest on life insurance payouts is one such exception, and it is important for beneficiaries to be aware of the potential tax implications when choosing how to receive the payout. Consulting with a tax professional can help ensure that any taxes are properly addressed.

Federal taxes on estate ownership transfer

Federal estate taxes are imposed on the transfer of property ownership after the owner's death. In 2023, federal estate taxes apply to estates valued at over $12.92 million, and in 2024, the maximum value increases to $13.61 million. This means that only the wealthiest Americans are subject to federal estate taxes.

The federal estate tax is levied on the decedent's gross estate, encompassing all financial and real assets of the deceased person. For taxpayers inheriting in 2023, the exclusion amount is $12.92 million, and it increases to $13.61 million for 2024.

It's important to note that federal estate taxes are not applicable in Texas, as the state does not impose a transfer tax on real estate. However, capital gains taxes charged by the federal government may still apply when selling a property in Texas.

While the primary purpose of life insurance is to provide a death benefit for loved ones, certain situations can make the payout taxable. For example, if the beneficiary is not named or has predeceased the insured, the payout becomes part of the insured's taxable estate. This could result in a significant tax bill, especially when both federal and state estate taxes are applied.

To avoid unintended tax consequences, it is crucial to consult with tax professionals and estate planning attorneys, especially when dealing with complex cases involving interest, proceeds beyond the death benefit, pre-tax dollars, or estate and inheritance taxes.

Profit from life insurance policy settlement

If you no longer need your life insurance policy, you can sell it to a third party for a one-time cash payment, known as a life settlement. This payment will be more than the surrender value but less than the actual death benefit. After the sale, the purchaser becomes the policy's beneficiary and assumes payment of its premiums.

A life settlement is different from a viatical settlement, which is for those with a terminal illness and a life expectancy of less than two years. A viatical settlement typically isn't taxable, whereas a life settlement may be.

In a life settlement, you sell your life insurance policy to another person or company. You receive a lump sum payout, and the buyer takes over future premium payments on your policy. When you pass away, the buyer receives the death benefit from your policy, not your heirs.

Who is eligible for a life settlement?

You usually need to be over 65 and have a permanent life insurance policy. If you have a temporary term life insurance policy, you may be able to sell it if it has a convertibility option, which swaps the term coverage for permanent coverage that won't expire.

The amount you receive depends on your age, health, and policy type. The payment will be smaller than your death benefit, so the buyer can make a profit when you pass away.

• It can be tough to determine whether you're getting a good price.
• Sales commissions can eat up a large portion of a life settlement.
• You'll likely have to pay taxes on at least some of the money you receive.
• If family members rely on you financially, they will no longer receive the safety net of the life insurance death benefit when you die.
• A life settlement could make you ineligible for public assistance.

• Surrender your policy for cash: You can cancel a permanent policy with cash value and receive a check for your balance.
• Convert to a paid-up policy: Use your cash value to create a paid-off policy that no longer charges premiums.
• 1035 to an annuity: Swap your life insurance policy for an annuity, which turns your cash value into future income.
• Use living benefits for a serious illness: If you need money for medical bills, see if your policy offers an accelerated death benefit.

Life insurance death benefit payouts are usually not taxable. However, there are certain situations where a life insurance death benefit may be taxable:

• If the beneficiary receives interest on a death benefit: If a beneficiary chooses to delay the payout or take the payout in installments, interest may accrue, and the interest paid to the beneficiary may be taxed.
• If the payout goes into a taxable estate: If a beneficiary was not named, or is deceased, the life insurance death benefit goes into the estate of the insured person and can be taxable along with the rest of the estate.
• If the policy involves three different people: In this case, the IRS considers the life insurance payout a gift from the policy owner to the beneficiary, and the policy owner may have to pay gift tax.

Additionally, if you have a cash value life insurance policy and you withdraw money that came from interest or investment gains, this portion is subject to income taxes.

Surrendering a life insurance policy

There are several reasons why you might want to surrender your life insurance policy. These include:

• You've found a better deal with a more affordable premium.
• You can no longer afford the premiums.
• You no longer need life insurance coverage.
• You need a large amount of cash quickly.

Before surrendering your policy, it's important to consider the potential tax implications. If you receive more funds than the policy's cost basis (the amount you paid in premiums), you may owe taxes on the excess amount. Additionally, if you have outstanding policy loans that exceed the policy's cost basis, you may also owe taxes.

To surrender your life insurance policy, follow these steps:

• Review your life insurance policy documents, including the contract, riders, amendments, and premium payment receipts. Look for information about cash surrender value, surrender charges, and other relevant terms.
• Contact your life insurance provider's customer service to initiate the surrender process.
• Fill out any necessary paperwork, such as a policy termination form or surrender request form.
• Receive the cash surrender value from your insurer via check or direct deposit.
• Consult with a tax expert and financial advisor to properly report the payout and determine the best way to save or invest your funds.

It's important to note that surrendering your life insurance policy may not be your only option for accessing your cash value. Some alternative options include borrowing against your cash value, withdrawing from your cash value, or using your cash value to pay premiums if your policy allows it. These options can help you maintain your life insurance coverage while still accessing your cash value.

Unpaid loans against a policy

Life insurance can be a valuable financial tool, providing peace of mind and financial security for loved ones in the event of your death. While the primary purpose of life insurance is to offer a death benefit, permanent life insurance policies also offer a cash value component that can be utilised during the policyholder's lifetime. This cash value can be used in several ways, including taking out a loan against the policy. However, it is essential to understand the risks and implications of unpaid loans against a life insurance policy.

When you borrow against your life insurance policy, the cash value serves as collateral for the loan. This means that if the loan is not repaid and the policy lapses or terminates, the unpaid loan amount will be deducted from the death benefit paid to your beneficiaries. Essentially, your beneficiaries will receive a reduced payout due to the outstanding loan. In addition, if the policy lapses with an unpaid loan, you may face tax consequences on the amount borrowed. Therefore, it is crucial to make timely repayments to protect the interests of your beneficiaries and avoid potential tax liabilities.

To mitigate the risks associated with unpaid loans, policyholders should be mindful of the following:

• Regular repayments: While life insurance loans do not typically have a strict repayment schedule, it is in your best interest to repay the loan as soon as possible. Allowing the loan to remain unpaid increases the interest owed and may put your policy at risk of lapsing if the amount owed exceeds the policy's cash value.
• Maintaining sufficient cash value: Keep track of your policy's cash value and ensure that the amount owed does not exceed this value. Regular repayments can help prevent the loan from consuming the entire cash value, which could jeopardise the policy.
• Timely premium payments: Continue paying your life insurance premiums on time to maintain active coverage. If the policy lapses due to unpaid premiums, any outstanding loan amount may trigger tax consequences.
• Communicate with beneficiaries: Inform your beneficiaries about the loan to ensure they are aware of the potential reduction in the death benefit. This transparency can help them plan accordingly and avoid financial surprises in the future.
• Consult a financial advisor: Before taking out a loan against your life insurance policy, discuss the decision with a financial advisor. They can guide you through the tax implications, risks, and alternatives to ensure you make an informed choice.

By following these guidelines and staying vigilant about loan repayments, you can minimise the risks associated with unpaid loans against your life insurance policy. Remember, the primary purpose of life insurance is to provide financial protection for your loved ones, so taking proactive steps to manage any potential deductions to the death benefit is essential.

Frequently asked questions