Life Insurance And Taxes: What Forms To File?

Life insurance payouts are usually not taxable, but there are some exceptions. For example, if the policy was transferred to you for cash or other valuable consideration, you may have to pay taxes on the proceeds. In this case, you will likely receive a tax form such as Form 1099-INT or Form 1099-R, which you can use to report the taxable amount. Additionally, if you borrow against your life insurance policy, the amount borrowed may be considered a taxable event if it exceeds the sum of the insurance premiums you have paid. Finally, if the insured person or policy owner dies, the IRS requires the executor of their estate to file Form 712, which reports the value of the life insurance policy's proceeds for estate tax purposes.

Life insurance payouts and taxation

Taxation of Life Insurance Proceeds

In most cases, life insurance proceeds received by a beneficiary due to the death of the insured person are not taxable and do not need to be reported as income. This means that the money paid out from a life insurance policy is generally tax-free for the beneficiary.

Interest on Life Insurance Payouts

However, it is important to note that any interest earned on the life insurance proceeds is taxable. This interest income should be reported accordingly.

Transfer or Sale of the Policy

If the life insurance policy is transferred or sold to another party for cash or other valuable consideration, the taxation rules change. In this case, the exclusion for the proceeds is limited to the sum of the consideration paid, any additional premiums paid by the new owner, and certain other amounts. This is known as the transfer-for-value rule.

Timing of Policy Transfer

The timing of the policy transfer also matters. If the insured person transfers the policy and dies within three years, the policy will likely be included in their estate, and the proceeds may be subject to estate taxes.

Life Insurance Payouts to the Estate

Life insurance death benefits may be subject to taxation if the payout is made to the estate of the insured or if the deceased person owns the policy on the date of their death. In these cases, the entire insurance payout is typically included in the estate and can be taxed accordingly.

Forms and Reporting

To report taxable events related to life insurance policies, specific forms are used. Form 1099-R and Form 1099-INT are commonly used to report taxable events, such as full surrender, partial withdrawal, loans, or dividend transactions. Form 712, the Life Insurance Statement, is also used to report the value of a life insurance policy's proceeds after the insured dies for estate tax purposes.

In summary, while life insurance payouts are generally not taxable for beneficiaries, there are several scenarios that can trigger taxation, including policy transfers, payouts to the estate, and interest earned on the proceeds. It is important to carefully consider the specific circumstances and consult official sources or tax professionals for the most accurate and up-to-date information.

Interest on life insurance proceeds

Life insurance proceeds are generally not taxable as income. However, any interest accrued on the proceeds is taxable and must be reported as interest received. This is usually reported using Form 1099-INT or Form 1099-R.

If you are the beneficiary of a life insurance policy, the death benefit you receive is typically not considered taxable gross income. However, if the payout is delayed and held by the insurance company for a period, you may be taxed on the interest generated during that time. This means that while you don't have to pay taxes on the entire benefit, you will owe taxes on the interest. For example, if a $500,000 death benefit earns 10% interest for a year before being paid out, you will only be taxed on the $50,000 growth.

The taxation of life insurance proceeds can be complex, and there are a few scenarios that can trigger tax liability. If the policyholder transfers the policy to you in exchange for cash or other valuable consideration, the exclusion for the proceeds may be limited. In this case, the taxable amount is generally based on the type of income document received, such as Form 1099-INT or Form 1099-R. Additionally, if the beneficiary is an estate rather than an individual, the person inheriting the estate may have to pay estate taxes.

To avoid paying taxes on life insurance proceeds, you can transfer ownership of the policy to another person or entity. This can be done through an irrevocable life insurance trust (ILIT), where you transfer ownership of the policy to the trust and cannot be the trustee. Alternatively, you can gift the policy to someone else, such as a competent adult or entity, by completing the proper assignment or transfer of ownership forms. Keep in mind that there are specific guidelines and considerations for each of these options, and it is always recommended to consult with a tax professional for personalized advice.

IRS Form 712

In the United States, the Internal Revenue Service (IRS) requires the reporting of the value of a life insurance policy's proceeds after the insured dies, for estate tax purposes. This is done through IRS Federal Form 712, also known as the Life Insurance Statement.

Form 712 is typically filed by the executor of the deceased's estate, along with an estate tax return, if one is required. The form must be completed for each life insurance policy in effect at the time of death. It identifies the policy's face amount, accumulated dividends, terminal dividends, the amount of the proceeds, and personal information about the insured for tax filing purposes. Additionally, it asks if the policy was transferred within three years before the death of the insured.

The purpose of Form 712 is to ensure that all taxes are in order when a life insurance policy is paid out. It is important to note that while life insurance proceeds received as a beneficiary due to the death of the insured are generally not included in gross income and do not need to be reported, any interest received on the proceeds is taxable and should be reported.

If you have a life insurance policy claim and need to obtain a copy of Form 712, you can download it from the IRS website or contact your insurance provider for assistance.

Transferring a policy and tax liability

Transferring ownership of a life insurance policy is possible, but it can have tax implications if not done properly. The transfer of a life insurance policy to another person or entity is generally done for estate tax savings or in a business context. It is common for trusts to own life insurance policies for estate planning flexibility, as the proceeds are not subject to estate tax.

When a policy is placed in an irrevocable trust, it may be sold to another trust with different terms, but this must be carefully executed. The "transfer for value" rule states that if a life insurance policy is sold for value, the proceeds will be subject to income tax. The income tax will apply to any amount over and above the cost of transferring ownership, plus any subsequent payments made by the new owner.

There are exceptions to the "transfer for value" rule, and a sale or transfer can be structured to avoid future income tax on the proceeds. For example, transferring a policy for value to a trust owned by the insured, their partner, or spouse is allowed. Survivorship life insurance policies can also be transferred, but with additional planning.

The IRS Federal Form 712 is used to report the value of a life insurance policy's proceeds after the insured dies for estate tax purposes. The form must be filed by the executor, along with an estate tax return if needed. Form 712 identifies the policy's face amount, accumulated dividends, terminal dividends, proceeds, and personal information on the insured. It also asks if the policy was transferred within three years of the insured's death.

To avoid tax issues when transferring a policy, it is important to use the insurance company's forms and ensure the new owner makes all premium payments. If the original owner continues to make payments, the IRS may consider them the true owner, and the proceeds will be included in their estate for tax purposes.

Life insurance policy loans

Here's how life insurance policy loans work in more detail:

Policy loans allow you to access the cash value of your life insurance policy by using that cash value as collateral. You can usually borrow a certain percentage of the cash value, typically up to 90%, and use the money as you wish. There is no formal approval process or credit check required, as you are borrowing against your own assets.

Repayment Options

You are not required to repay a policy loan before you die. However, if the loan is not repaid, the death benefit will be reduced by the amount owed, including any interest that has accrued. You have the option to make periodic payments or only pay the annual interest. If you choose to pay only the interest, the principal amount will continue to accumulate interest, increasing the total amount owed.

Pros and Cons of Life Insurance Policy Loans

However, there are also some downsides to consider. If the loan is not repaid, the unpaid principal and interest can reduce the death benefit, potentially leaving insufficient funds for beneficiaries. Additionally, if the loan amount exceeds the policy's cash value, the policy could lapse and be terminated by the insurance company. In this case, the outstanding loan balance may be considered taxable income, resulting in a significant tax bill.

In most cases, money borrowed against a life insurance policy is not taxable, as long as the amount borrowed is equal to or less than the sum of the insurance premiums paid on the policy. However, if the policy lapses or is cancelled, and there is an outstanding loan balance that exceeds the sum of the premiums paid, the excess amount will be considered taxable income.

Frequently asked questions