Written by: Levi Geissel
“Is a life insurance benefit taxable?”. This is one of the most common questions we receive as advisors when discussing life insurance. Rightfully so, because it is a very important consideration to be mindful of.
In most scenarios, life insurance proceeds paid to beneficiaries are not taxable. However, there are instances where proceeds are taxed. It is important to understand how taxation may occur, so you and your heirs avoid any major surprises down the road.
Are Life Insurance Proceeds Taxable?
One of the most alluring aspects of life insurance is the tax-free payout beneficiaries receive. An instant lump-sum benefit can be extremely helpful as beneficiaries are able to use it as they see fit without having to forfeit anything to the tax man.
Although it is uncommon, there are instances where beneficiaries may need to pay taxes on proceeds. Here are the scenarios where life insurance may be taxable to beneficiaries:
Death benefit payout is delayed or made in installments
Most insurers hold funds to be paid to beneficiaries in an interest-bearing account. Therefore, if a beneficiary chooses to delay their lump-sum payout or receive their payout in installments, they may need to pay income taxes on any interest generated during the payout period. Electing to do an immediate lump-sum payment would avoid any interest accrual and result in a tax-free payout.
One item to note here is that you are not paying taxes on the benefit, simply paying taxes on the interest income that was generated.
Death benefit is part of your estate and you have a taxable estate
If the death benefit is considered part of your estate – your estate is listed as a beneficiary, or the beneficiary dies before you do – the death benefit could be subject to taxation if the value of your estate surpasses federal and state exemption amounts.
The federal exemption is $12.06 million for 2022, meaning if the value of your estate is below that, no estate tax will be owed. In other words, if the value of your estate (including life insurance proceeds) will be below that figure, you do not need to worry about the federal estate tax.
Not every state has an estate or inheritance tax, so it is important that you work with a tax professional to understand how your life insurance may affect your state’s estate/inheritance tax. It is also important to note, the federal estate tax is only locked in through 2025 and may be subject to change in future years.
It is possible for the death benefit to not be listed as part of your estate. One option is to transfer the policy ownership to someone else before passing away. If one goes this route, they should be mindful of the three-year rule.
The three-year rule states that a policy is still part of your estate if you pass away within three years of the transfer of ownership. Another option to consider would be an irrevocable life insurance trust (ILIT). ILITs are also subject to the three-year rule and are very complex with specific guidelines on how they are to be funded. If you would like to learn more about ILITs please click the following link to an Investopedia article that discusses the pros and cons of ILITs in greater detail.
Along with speaking to a CPPA, these items make it very important to talk with an estate planning attorney as well to discuss your individual situation to make sure you are making the right decisions with how your policy will be taxed based in different scenarios.
Do you pay taxes on life insurance?
There are some instances where policy owners can cause taxation either to themselves or their beneficiaries once a death benefit has been triggered. The following situations are ways life insurance can be taxed:
Policy owner surrenders the coverage
Term insurance owner’s do not need to worry about this as term policies do not carry cash value. Permanent life insurance coverage does carry cash value which may be subject to taxation should the policy owner decide to cancel (surrender) their coverage.
Most cash value policies grow tax deferred. They also have policy basis, which is the amount of premiums paid into the policy less any dividends received. Not all policies pay dividends, but the IRS considers dividends as a return of premium. When a policy is surrendered, the amount received (known as the surrender value) is the cash value minus any surrender charge the insurer has. The amount you are taxed on is the surrender value minus the policy basis.
If a policy is considered a modified endowment contract (MEC) by the IRS, the policy basis is not allowed to be withdrawn tax-free. A policy becomes a MEC due to overfunding of premiums. It is worth noting that death benefits paid from a MEC are typically flow to beneficiaries tax-free.
In these instances, it is important to reach out to a CPA for professional tax advice.
Policy owner withdraws money from cash value or takes out a policy loan and coverage ends
As mentioned above, there are two components with cash value – policy basis and interest/investment earnings. As long as the policy is not a MEC, the policy basis can be withdrawn tax-free. Any amount withdrawn above the policy basis may be subject to income taxes.
One option cash value life insurance policy owners choose to do is take out a policy loan. This is simply taking a loan from yourself. You use the cash value that you have contributed towards in the policy and loan yourself the funds with no interest.
Policy loans are not taxable as long as the policy remains in-force. However, if a loan has not been repaid and the policy is surrendered or terminated (coverage lapses), the policy owner may be facing a tax bill. The balance to be taxed would be the amount of outstanding loan minus the policy basis.
It is common for policy owners to withdraw the policy basis and then take out a loan on cash value amounts above that figure as it allows them to have access to more of their cash value tax-free. It is important to understand how your policy is designed and to make sure the policy stays in-force to avoid any taxation down the road and to ensure beneficiaries receive a death benefit.
Policy owner sells the coverage
We have all seen commercials on companies offering to buy existing life insurance policies. There are two types of options under this umbrella – viatical settlement and life settlement.
Viatical settlements occur when a terminally ill policy owner sells their coverage. Thankfully, the IRS considers this a disbursement of death benefit and funds received are not taxable.
Life settlements occur when a policy is sold when an individual is not terminally ill. Since this is not considered a death benefit payment, proceeds received may be taxed. Depending on how much you receive, both income taxes and capital gains taxes may come into play. Income taxes would be owed on any proceeds that exceed the policy basis and capital gains taxes would be owed on any proceeds that exceed the policy’s cash value.
If you are looking to get a new cash value policy, the IRS does allow for a 1035 exchange. This allows policy owners to transfer the cash value to their new policy without having to pay taxes. Please note, once a policy is considered a MEC, moving the cash value to a new policy will not negate the MEC status.
Are life insurance premiums tax deductible?
Unfortunately, we are not able to have our cake and eat it too. The IRS considers premiums paid into an individual policy as a personal expense and they cannot be deducted.
There are certain circumstances where a business owner may deduct life insurance premiums. However, there are specific rules around this, and you will want to connect with a tax professional to see if this is applicable to your situation.
Questions on life insurance?
If you have any questions about your existing policy or thinking about obtaining a policy, we urge you to speak to an independent financial advisor to discuss your situation.
There are a lot of options in the life insurance industry, and it can get very confusing and complex between different policies. If you would like to have a discussion on life insurance with one of our independent financial advisors at the Finity Group, please reach out and we would be happy to set up an initial consultation.
Related Blog Posts:
- Why is Life Insurance Important?
- Do I Need Life Insurance? 4 Reasons Why You Might
- Term vs. Whole Life Insurance
- How Much Life Insurance Do I Need?
Life insurance can be an investment product. Investing involves the risk of loss, including total loss of principal. Past performance is no predictor of future returns. This should not be construed as individualized investing advice. Consult with your investment advisor to develop an appropriate investment strategy for your circumstances.