Life Insurance Beneficiaries: Taxable Or Not?

When a policyholder passes away, the proceeds or death benefits are paid to the named beneficiary or beneficiaries. In most cases, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income, so it isn't subject to income or estate taxes. However, there are exceptions where a beneficiary may be taxed on some or all of the proceeds. For example, if the payout is structured as multiple payments over time, the interest accrued may be taxable. Similarly, if the policyholder withdraws or takes out a loan against the policy, the amount withdrawn above the total premiums paid may be taxable. If the policyholder surrenders or sells the policy, any amount received above the policy's cash value may also be taxed as income. Additionally, if the policy is part of an estate, and its value exceeds federal and state thresholds, estate taxes may apply. While life insurance proceeds are generally tax-free, understanding the specific circumstances and seeking tax advice is essential for beneficiaries.

Lump-sum payments are usually tax-free

Life insurance payouts are generally not taxable, and beneficiaries typically receive the death benefit tax-free. Lump-sum payments are especially unlikely to be taxed. However, there are certain scenarios where taxes may apply, and it's important to understand these exceptions to make informed decisions.

When a policyholder passes away, the named beneficiary or beneficiaries receive the death benefit, which is usually not considered part of their gross income and is therefore tax-free. This applies to term, whole, or universal life insurance policies. However, if the payout is structured as multiple payments over time, such as an annuity, the interest accrued may be subject to taxes. In such cases, only the interest portion of the payments is taxable, while the principal amount remains tax-free.

It is important to note that if the policyholder withdraws or takes out a loan against the cash value of a whole life insurance policy, and the amount withdrawn or loaned exceeds the total premiums paid, the excess may be subject to income taxes. Similarly, if a policy is surrendered or sold, and the cash received exceeds the cumulative premiums, the excess may be taxable.

Additionally, if the policyholder names their estate as the beneficiary, the death benefit becomes part of the estate, and if the total value exceeds the federal estate tax threshold, estate taxes may be owed. As of 2023, the federal estate tax threshold is $12.92 million. It is important to consult with a tax professional or financial advisor to understand the specific tax implications based on individual circumstances.

While lump-sum payments to beneficiaries are generally tax-free, it is always advisable to seek guidance from a qualified tax professional to navigate the complexities of life insurance and tax regulations.

Interest accrued on annuities is taxable

Taxation of Interest Accrued on Annuities

Non-qualified annuities are funded with post-tax money, and only the interest accrued is taxable as income when it is withdrawn. Qualified annuities, on the other hand, are funded with pre-tax money, and the entire withdrawal amount, including the principal, is taxable as income.

Taxation of Life Insurance Proceeds

In general, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income and is not subject to income or estate taxes. However, there are some cases when a death benefit can be taxed. For example, if the payout is set up to be paid in multiple instalments, these payments can be subject to taxes as they include proceeds and interest.

Withdrawing/loaning against a policy may be taxable

Withdrawing or taking out a loan against your life insurance policy may be taxable under certain circumstances. Firstly, it's important to note that the loan itself is generally not considered taxable income. However, if you withdraw or loan an amount that exceeds the total premiums you have paid into the policy, the excess may be subject to taxation. This is because the earnings or interest accrued on the policy grow tax-deferred while inside the policy, and upon withdrawal, these gains are treated as taxable income.

For example, if you have a cash value life insurance policy with a cash value of $18,000 and your basis (total premiums paid minus dividends or previous withdrawals) is $12,000, withdrawing up to $12,000 would typically be tax-free. However, if you withdraw $15,000, you would need to pay income tax on the additional $3,000. It's important to note that this income tax is separate from the surrender charges that may be applied by your insurance company when you make a withdrawal.

Additionally, if you surrender your policy or if it lapses, and the amount you owe exceeds what you have paid in, you may also face a tax bill. In this case, you would need to pay income tax on any earnings from the investment. However, if you simply take out a loan against the policy and it remains in force, you generally won't have to pay income taxes on the loan amount.

It's worth noting that withdrawing or taking out a loan against your life insurance policy can have other consequences, such as reducing the death benefit that your beneficiaries will receive and potentially causing your policy to lapse if the loan and interest accrue and are not repaid. Therefore, it's important to carefully consider your options and consult with a financial advisor before making any decisions regarding your life insurance policy.

Surrendering a policy may be taxable

Surrendering a life insurance policy may come with tax consequences. If you are the policyholder and you surrender your life insurance policy for cash, you may be taxed on the amount you receive over the cost of the policy. This is known as the cash surrender value, and it is based on your cash value, which is the component of a permanent life insurance policy that helps you build cash value through regular premium payments.

The cash surrender value of a life insurance policy can be taxable. Any amount received over the policy's basis, or the amount paid in premiums, can be taxed as income. For example, if you surrender your policy and receive a payout of $10,000, but you only paid $8,000 in premiums, the additional $2,000 may be taxed as regular income.

There are a few other scenarios that may result in potential tax consequences when surrendering a life insurance policy. If you have outstanding policy loans that exceed the policy's cost basis, the insurance company will deduct the loan amount and any interest from the cash surrender value. In this case, you will owe income tax on the lower surrender value if it exceeds the amount you paid in premiums.

Additionally, surrendering your policy earlier in the term may result in a lower cash surrender value since the cash value will be smaller, and you may owe surrender charges. However, if you surrender the policy later, you could receive a larger payout as the cash value will be larger, and you will pay fewer fees.

It is important to consult with a tax expert and financial advisor before surrendering your life insurance policy to understand the potential tax implications and make an informed decision.

Estate tax may apply if the policy is worth over $12.92 million

If the deceased's estate is worth over $12.92 million, their beneficiaries may have to pay estate taxes on the proceeds of their life insurance policy. This is because, 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 on the proceeds over the allowed limit.

The estate tax threshold was $12.06 million for decedents who passed away in 2022, and the exclusion amount for 2023 is $12.92 million. The top-tier tax rate is capped at 40%. Many of the changes enacted by the Tax Cuts and Jobs Act, including the higher federal estate tax exclusion, are currently set to expire at the end of 2025 unless Congress extends them.

If the life insurance policy is payable to the estate, either directly or indirectly, or to named beneficiaries if the deceased possessed any "incidents of ownership" in the policy at the time of their death, then the value of the life insurance proceeds is included in their gross estate.

If the proceeds are included in the deceased's estate, the person or people inheriting the estate may have to pay estate taxes. This is known as the three-year rule, which states that any gifts of life insurance policies made within three years of death are subject to federal estate tax.

To avoid paying estate taxes on life insurance proceeds, a taxpayer will need to transfer ownership of the policy to another person or entity. This can be done by creating an irrevocable life insurance trust (ILIT), which will own the life insurance policy rather than the deceased. This means the proceeds will not be included in their estate. However, the original owner must forfeit any legal rights to change beneficiaries, borrow against the policy, surrender or cancel the policy, or select beneficiary payment options.

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