Tax And Life Insurance: Beneficiaries And Implications

Life insurance is a financial product that provides peace of mind and financial security for loved ones after the policyholder's death. However, the question of whether beneficiaries are taxed on their life insurance payout is a complex one. While in most cases, beneficiaries are not taxed on their life insurance payout, there are some exceptions and special circumstances that can lead to taxation. Understanding these scenarios is crucial for beneficiaries to navigate their tax obligations effectively. This guide will explore the tax implications for life insurance beneficiaries, providing valuable insights for individuals seeking to maximize their financial benefits.

Are life insurance proceeds taxable?

In most cases, life insurance proceeds are not taxable. However, there are certain circumstances in which they may be subject to tax. Here is a detailed overview of when life insurance proceeds are taxable and when they are not.

When Life Insurance Proceeds Are Not Taxable

Generally, life insurance proceeds are not considered taxable income for the beneficiary. This means that, in most cases, you do not have to pay taxes on the death benefit you receive as a beneficiary. The Internal Revenue Service (IRS) states that life insurance proceeds received by a beneficiary due to the death of the insured person are typically not includable in gross income and do not need to be reported as taxable income.

When Life Insurance Proceeds May Be Taxable

While life insurance proceeds are usually tax-free, there are a few exceptions to this rule:

• Interest: If the death benefit is paid out in installments and the remaining portion earns interest, that interest is typically taxable for the beneficiary. This includes specific income payouts, retained asset accounts, and lifetime or fixed-period annuities.
• Paid to an Estate: If the life insurance payout is made to the insured's estate instead of a specific individual or entity, it may be subject to estate taxes. This can increase the value of the estate and potentially lead to higher estate taxes.
• Different Owner and Insured: If the owner of the policy is not the same as the insured person, the payout to the beneficiary could be considered a taxable gift.
• Payout Exceeds Premiums Paid: If the policyholder has withdrawn money or taken out a loan against the policy, and the amount withdrawn exceeds the total amount of premiums paid, the excess amount may be taxable.
• Surrendering the Policy: When you surrender a life insurance policy, any funds received over the policy's cash basis will generally be taxed as regular income.
• Employer-Paid Group Life Plan: In certain cases, an employer-paid group life plan that pays out more than a specified amount (e.g., $50,000) may be taxable, according to the IRS.
• Estate Tax Threshold Exceeded: If the life insurance proceeds are included as part of the deceased's estate, and the total value exceeds the federal estate tax threshold, estate taxes must be paid on the amount over the allowed limit. For 2023, this threshold was $12.92 million.
• Inheritance Tax: Inheritance tax is imposed on the recipient for any inherited cash payouts, properties, and other assets. Currently, only a few states in the US enforce this tax, including Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania.
• Generation-Skipping Tax: This tax is imposed on assets that skip a generation and is only enforced when they exceed certain thresholds, similar to the estate tax.

When are death benefits taxable?

In most cases, beneficiaries are not required to pay taxes on their life insurance payout. However, death benefits can be taxed in certain situations.

Firstly, if the payout is set up to be paid in multiple instalments, the payments can be taxable. For example, an annuity paid regularly over the life of the beneficiary may include proceeds and interest, which can be subject to taxes.

Secondly, if the policyholder has withdrawn money or taken out a loan, and the money withdrawn or loaned exceeds the total amount of premiums paid, the excess may be taxable.

Thirdly, if the policy is surrendered, any funds over the policy's cash basis will be taxed as regular income.

Fourthly, in some cases, an employer-paid plan that pays out more than $50,000 may be taxable according to the Internal Revenue Service (IRS). Otherwise, the death benefit is usually paid to beneficiaries tax-free.

Fifthly, if the death benefit and the total value of the deceased's estate exceed limits, estate taxes must be paid on the proceeds over the allowed limit. According to the IRS, if life insurance proceeds are included as part of the deceased's estate and together exceed the federal estate tax threshold of $12.92 million (as of 2023), estate taxes must be paid.

Lastly, if the beneficiary receives interest on the death benefit, this interest is usually taxable.

How to avoid paying taxes on a life insurance payout?

In most cases, beneficiaries don't need to pay taxes on their life insurance payout. However, there are a few exceptions and circumstances where taxes may be applicable. Here are some ways to avoid paying taxes on a life insurance payout:

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, consider naming a person as the beneficiary, which reduces the likelihood of being taxed.

Create an irrevocable life insurance trust (ILIT)

You can transfer ownership of the policy from yourself to an ILIT, effectively removing it from your estate. However, keep in mind that this type of trust cannot be revoked once established. By placing the policy in a trust, you can maintain some legal control over it and ensure prompt payment of premiums.

Be mindful of gift tax limits

The annual gift tax exemption and lifetime exclusion amount can help you avoid taxation if you ensure your policy's cash value does not exceed these limits. For 2024, the annual gift tax exemption is $18,000, and the lifetime exclusion amount is $13.61 million.

Transfer policy ownership

You may consider transferring ownership of the policy to another person or entity. However, note that if you transfer it within three years of your death, the IRS will treat it as if it still belongs to you, and the value beyond what was paid for the policy will be considered taxable.

Avoid interest accumulation

If the payout is delayed and accumulates interest before being disbursed, the beneficiary may have to pay taxes on the interest earned. To avoid this, ensure that the payout is received promptly and does not accrue interest.

Avoid taxable estates

If no beneficiary is named in the policy, the life insurance benefits will typically go into a taxable estate. To avoid this, make sure to designate a beneficiary to receive the payout directly, reducing the likelihood of taxes.

What are the different types of life insurance taxes?

Life insurance death benefits are typically tax-free, but there are a few exceptions. Here are some of the different types of life insurance taxes:

Interest Taxes

If the beneficiary receives the death benefit in installments, any interest that accrues on the unpaid balance may be subject to income tax. This is because, although the lump-sum proceeds of the life insurance policy are usually not taxable, any interest earned is considered taxable income.

Estate Taxes

If the beneficiary is the insured's estate, rather than a specific individual or entity, the death benefit may be subject to estate taxes. This is because the value of the life insurance proceeds is included in the gross estate if it is payable to the estate or to named beneficiaries if the insured had any "incidents of ownership" in the policy at the time of death.

Gift Taxes

If the owner of the policy is different from the insured, the payout to the beneficiary could be considered a taxable gift. This is known as the Goodman Triangle, where three different individuals are involved in the policy: the policy owner, the insured, and the beneficiary. To avoid this, financial advisors suggest that only two parties be involved in the policy.

Taxes on Policy Loans or Withdrawals

Policy loans or withdrawals from the cash value of a permanent life insurance policy can trigger taxes if the amount withdrawn exceeds the total amount of premiums paid into the policy (the cost basis). In this case, the excess amount is typically taxed as ordinary income.

Taxes on Policy Surrender

Surrendering a permanent life insurance policy for its cash surrender value (CSV) can also result in taxes if the CSV is higher than the amount of premiums paid. The excess amount is usually taxed as ordinary income.

Taxes on Dividends

Participating whole life insurance policies may pay dividends that earn interest. While the dividends themselves are not taxed, the interest earned is considered taxable income and must be reported.

When are life insurance premiums taxable?

Life insurance premiums are generally not tax-deductible. However, if you are a business owner, you may be able to write off premiums paid on behalf of employees. The rules for doing so can be complex, so it is recommended that you consult a licensed tax professional if you have any questions.

There are some instances where life insurance premiums may be taxable. For example, if the total amount of premium paid into a policy exceeds a certain limit, the policy may be classified as a Modified Endowment Contract (MEC). MEC policies receive less favourable tax treatment than non-MEC policies. Additionally, if the policy is considered carried directly or indirectly by the employer and the coverage exceeds $50,000, the imputed cost of coverage in excess of this amount must be included in income and is subject to Social Security and Medicare taxes.

Furthermore, if the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated during that time. This also applies if the policy accrues interest; the beneficiary will have to pay taxes on the interest accrued.

It is important to note that the information provided here is general in nature and may not apply to all specific situations. For specific tax advice, please consult a tax professional or the Internal Revenue Service (IRS).

Frequently asked questions