Life Insurance Payments: Are They Taxable?

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, there is no federal income tax on life insurance payouts. However, there are some exceptions and unique circumstances that can make these proceeds taxable. This paragraph aims to introduce the topic and provide a general overview of the tax implications associated with life insurance payments.

Interest on life insurance payouts is taxable

Life insurance is often exempt from federal income tax. However, any interest accrued on the payout is taxable. This means that if you receive a payout in installments, any interest that accumulates on those payments will be taxed as regular income.

For example, if you receive a death benefit of $500,000, but it earns 10% interest for one year before being paid out, you will owe taxes on the $50,000 growth. The death benefit itself is typically not taxed, but the interest that builds up on those payments is considered taxable income. Therefore, it is important to report this interest on your taxes.

If you have chosen to receive your life insurance payout in an interest-bearing account, it is important to note that the interest earned will be taxable. While this option may provide flexibility and convenience, the interest earned may be subject to taxation.

In addition, if you have a permanent life insurance policy and take out a loan against the cash value, you can generally do so without immediate tax implications. However, if there are unpaid loans against the policy when it is cancelled or lapses, they will be deducted from the death benefit, reducing the amount your beneficiaries will receive.

To avoid unexpected tax complications, it is recommended to regularly review your beneficiaries and policy details. Consulting with a tax professional can also help you understand your specific situation and determine if your life insurance proceeds are taxable.

Estate taxes may apply if the estate's value exceeds the federal threshold

Life insurance proceeds are generally not taxable as income. However, if the value of the estate exceeds the federal threshold, estate taxes may apply.

The federal estate tax exemption is $12.06 million per individual for 2022, and $12.92 million for 2023. If the value of an estate exceeds this threshold, it will be subject to a tax rate of up to 40%. This is separate from state estate and inheritance taxes, which are enforced by 17 states and Washington, D.C. State estate tax exemption amounts range from $1 million to $7 million, and tax rates can be as high as 20%.

To avoid estate taxes, it is recommended that individuals do not name their estate as the beneficiary of their life insurance policy. This is because doing so increases the value of the estate and could subject heirs to high estate taxes. Instead, it is advisable to name a specific person as the beneficiary, reducing the likelihood of estate taxes.

Another strategy to avoid estate taxes is to set up an irrevocable life insurance trust (ILIT). By transferring ownership of the life insurance policy to an ILIT, the policy is removed from the individual's taxable estate. However, it is important to note that the three-year rule applies to ILITs. This means that if the individual dies within three years of transferring the policy to the trust, the proceeds will be included in their estate and taxed accordingly.

Inheritance tax may apply in certain states

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. While most life insurance payouts are tax-free, there are exceptions. If the death benefit is paid out in instalments and the remaining portion earns interest, that interest is taxable.

When Inheritance Tax May Apply

If you are the beneficiary of a life insurance policy, there are certain circumstances where you may have to pay inheritance tax on the payout.

The Beneficiary Receives Interest

Although the lump-sum proceeds of a life insurance policy are typically not considered taxable income, any interest earned is taxable. Funds that haven't been disbursed could accrue interest over time.

The Money is Paid to an Estate

If the money is paid to the insured's estate rather than a particular beneficiary, it could be subject to inheritance tax. In 2024, estates over $13.61 million owe estate tax.

The Owner and the Insured are Different

If the owner of the policy is not the same as the insured, the payout to the beneficiary could be considered a taxable gift.

Tips to Avoid Paying Inheritance Tax on a Life Insurance Payout

If you're concerned about inheritance tax on a life insurance policy, there are a few strategies you can consider to potentially reduce or avoid it.

Transfer Policy Ownership

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

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, it's important to remember that this type of trust cannot be revoked once it's established.

Be Aware of Gift Tax Limits

The annual gift tax exclusion limit for 2023 is $17,000, and the lifetime exclusion amount is $13.61 million. By ensuring that your policy's cash value does not exceed these limits, you may be able to avoid or minimize inheritance tax.

While inheritance tax on life insurance payouts is only enforced in a handful of states, it's important to be aware of the circumstances that can trigger this tax. By understanding the rules and seeking professional tax advice, you can make informed decisions to potentially reduce or avoid inheritance tax liability.

Generation-skipping tax may apply if assets skip a generation

The Generation-Skipping Transfer Tax (GSTT) is a federal tax imposed on transfers that skip a generation, such as from grandparent to grandchild. The GSTT was introduced in 1976 to prevent wealthy families from avoiding estate taxes by passing on their wealth to grandchildren, instead of their children, thus avoiding estate taxes with each passing generation.

The GSTT is equal to the highest federal estate tax rate, which is currently 40%. This tax only applies when the transferred amount exceeds a certain threshold. For 2024, the threshold is $13,610,000 per person or $27,220,000 for a married couple. This threshold is indexed for inflation and will grow each year until 2025, after which it is scheduled to revert to its baseline of $5 million, indexed for inflation.

The GSTT affects only the very wealthy, as the threshold for 2024 is $13.61 million per person. This is set to drop significantly in 2026.

There are two types of skips: direct and indirect. A direct skip occurs when the transferor gifts assets directly to a skip person, and they have immediate ownership rights. An indirect skip involves a transfer that has intermediate steps before reaching a skip person, such as when money is transferred to a trust that may eventually distribute assets to a skip person.

The GSTT can be avoided by choosing the beneficiary wisely. One common mistake is to make the beneficiary "payable to my estate", which can raise the value of the estate and make taxes more likely. Instead, naming a person as the beneficiary makes it less likely that the GSTT will be incurred.

Naming an estate as beneficiary may increase tax liability

Life insurance proceeds are generally not taxable, and beneficiaries usually do not have to report them as gross income. However, there are certain instances where naming an estate as a beneficiary can increase tax liability and result in unfavorable tax implications.

Firstly, if there is a gap in beneficiary designations, an estate may become the "default" beneficiary of insurance proceeds or retirement plans. This typically occurs when designated beneficiaries pass away before the policyholder and a new beneficiary is not named. In such cases, the insurance proceeds are distributed to the estate and then passed on to heirs according to the terms of the will. This distribution process can trigger tax consequences and increase the overall tax liability.

Additionally, when an estate is the beneficiary, the insurance proceeds may be exposed to extra fees, risks, and creditors. The funds will have to go through probate, which is a court-supervised process of administering an estate. Probate can be costly and time-consuming, potentially delaying the distribution of funds to beneficiaries. During this time, any investments within the estate may be frozen and subject to market risks, reducing the overall value of the inheritance.

Moreover, naming an estate as a beneficiary can result in limited post-death distribution options and a faster payout rate. This can increase the total income tax liability on the funds. If the policyholder dies before their required beginning date for annual minimum distributions with the estate as the beneficiary, the insurance proceeds must be distributed within five years after their death. In contrast, naming a spouse, child, or qualifying trust as a beneficiary would provide more favorable distribution options, allowing for a longer payout period and potentially reducing the income tax bill.

Furthermore, there are specific tax consequences associated with naming an estate as a beneficiary. The proceeds may become part of the taxable estate, potentially triggering federal estate tax and state death tax. While federal law exempts the first $11.7 million from federal estate tax, any amount exceeding this threshold may be subject to taxation.

In conclusion, while there may be rare advantages, naming an estate as a beneficiary of life insurance or retirement plans is generally not advisable due to the increased tax liability and unfavorable distribution options. It is essential to consult with a qualified tax professional or estate planning attorney to navigate these complex issues effectively.

Frequently asked questions