Life insurance policies can offer great financial security for your loved ones in the event of your death. The provided benefits can replace lost income and cover necessary finances, such as funeral and burial expenses or everyday bills. When it comes to benefits, though, policyholders can have a lot of questions about life insurance.
Because a life insurance payout can be large, policyholders often wonder whether their life insurance is taxable. Most of the time, your beneficiaries won’t have to worry about paying any taxes on life insurance death benefits. There are specific situations, however, in which taxes could come into the equation.
- Life insurance is an asset, not an expense
- 8 times when life insurance could be taxable
- When you take incremental payouts vs. a lump sum
- When your assets exceed the estate tax
- When the generation-skipping transfer tax applies
- When the gift tax applies
- When you have a cash value policy
- When you have certain group life insurance
- If you earn interest on installment or delayed payments
- If you sell your policy to someone else
- Bottom line
Life insurance is an asset, not an expense
To understand how life insurance works, it’s important to know that life insurance is an asset and not an expense. This means it’s a valuable resource. Yes, you may have to pay premiums to keep your life insurance policy active, but the end payout will typically far outweigh anything you’ve paid on premiums. In effect, you’re purchasing a future asset when you buy life insurance.
Money paid out upon your death is called a death benefit. Because death benefits aren’t normally taxable, their value rises significantly, and for this reason, your life insurance policy is truly an asset.
In certain situations, your life insurance benefits are taxable. But if you understand how these situations work, you can be better prepared when looking into your own life insurance policy and providing for your loved ones.
8 times when life insurance could be taxable
1. When you take incremental payouts vs. a lump sum
The terms of your life insurance policy will determine how your death benefits are set up and paid out. In most cases, the amount of coverage you originally purchased will be paid out in a lump sum upon your death. Because this lump sum is considered a reimbursement instead of income, it’s not taxable.
Lump sum death benefits are typically associated with term life insurance policies. These are policies that provide life insurance coverage over a set number of years, called a term. If you die within the specified term, your beneficiaries have the option to receive a tax-free lump-sum payout. However, not everyone chooses to receive the payout as a lump sum. That’s what Michael Quinn, owner and director of marketing at Life Insurance Blog, says.
“Sometimes beneficiaries and policyholders elect to have their life insurance policy so the beneficiary receives the death benefit payout in monthly or annual payments instead of the typical lump sum,” Quinn says. “When that's the case, most of the policy will earn interest over time, and the interest is then considered taxable income. This also occurs when the death benefit earns interest in the time period from the policyholder’s death and payment to the beneficiary.”
Basically, if you or your life insurance beneficiary have elected to receive incremental payouts, any interest earned over time is considered income and would be taxable. Most beneficiaries elect for a lump sum payout, but there are some cases in which it may be easier to handle payouts in increments instead of receiving a large sum of money all at once. In these cases, just remember any interest earned will be taxed.
2. When your assets exceed the estate tax
Your assets may be taxable if they exceed the estate tax threshold. According to Kathryn Casna, a licensed insurance agent.
“If your estate value tallies $12.92 million or more, including the death benefit payout in 2023, and your estate is your beneficiary, the death benefit from your life insurance proceeds will be subject to estate taxes. You can avoid this tax by naming your spouse as your beneficiary, though if funds remain at the time of their death, their beneficiaries may pay taxes on them. Or, you can transfer ownership of your policy to another person, such as an adult child.”
The federal estate tax threshold for 2023 is $12.92 million, so average income earners shouldn’t have to worry about having a taxable estate. On the other hand, if you have a high income and you name your estate as your life insurance beneficiary, you may have to pay.
On the bright side, although there is a federal estate tax, there is no federal inheritance tax. The difference between estate and inheritance taxes is who has to pay the tax. With estate taxes, your estate is responsible for paying the taxes. The total value of the estate is taken into consideration, and the person in charge of the estate files the tax return. With inheritance taxes, the individual receiving the inheritance is responsible for paying the taxes.
Inheritance tax only exists at the state level, and there are very few states that impose it. In addition to the federal estate tax, though, some states also impose a state estate tax. In certain cases, an estate may have to pay taxes at both the federal and state levels. To avoid paying estate taxes on your life insurance benefits, you might consider setting up an irrevocable trust as the owner of your policy.
TipGuy Baker, Ph.D., founder of Wealth Teams Alliance, says, “If the estate is subject to tax, then some or all of the insurance proceeds would be estate taxed if they exceed the exemption. To avoid this, the owner could be a third party, where the life insurance premiums are paid by loans or gifts. A trust is an ideal owner of the insurance. However, inter vivos trusts do not exempt the life proceeds from estate tax; only irrevocable trusts can do that if they are set up properly.”
With an irrevocable life insurance trust, the recipients of your estate can avoid having to pay estate taxes on your life insurance benefits. Once your life insurance policy is purchased by or moved into an ILIT, the terms are generally set and cannot be changed, hence irrevocable.
To make sure your estate planning properly accounts for the tax rules in your state, be sure to do your research before purchasing life insurance.
3. When the generation-skipping transfer tax applies
As the name suggests, the generation-skipping transfer tax applies when there is a transfer of assets from one individual to another who is two generations away from the original individual. This tax also includes any recipient (related or not) who is at least 37-and-a-half years younger than the donor. For instance, if a grandparent wants to include life insurance benefits in their estate for a grandchild, that sum could be taxed by 40% by the IRS.
Fortunately, large exemptions are in place, so most people can avoid this tax. The 2023 lifetime exemption amount for the GSTT is $12.92 million, which is the same as the federal gift and estate tax threshold. If you go over that amount, only the amount in excess would be taxed.
4. When the gift tax applies
A gift is classified as an asset that is given to someone else without expecting to be paid back for it. The annual gift tax exclusion for 2023 is $17,000. This means you can give another individual a gift this year that’s worth up to $17,000 without having to worry about taxes. If you go over that $17,000 threshold, you would need to file a gift tax return.
That said, gift tax is closely linked to the 2023 $12.92 million lifetime federal gift and estate tax threshold. If you give a gift that’s worth more than $17,000, the excess amount would take away from the value of your lifetime federal gift and estate tax threshold, but you wouldn’t have to pay taxes until that higher threshold is reached.
To put this in real-world terms, let’s say you gave close friends and family members 10 gifts worth $1 million each in 2023. The annual gift exclusion is $17,000 per person, so each gift is $983,000 over the annual threshold. In total, that’s $9.83 million toward the lifetime gift and estate tax threshold, which leaves you with $3.09 million left over to gift or pass down. If your life insurance policy leaves $4 million to your estate, that clears the remaining $3.09 million left of your lifetime threshold and actually exceeds the threshold, and that excess amount could be taxable.
Overall, this shouldn’t apply to most people, but it’s important information to keep in mind if you’re dealing with numbers like these.
5. When you have a cash value policy
Can you be taxed on cash-value life insurance policies? According to Casna, “The cash value of your life insurance may be taxable if you withdraw all or part of it before your policy matures.” Term life insurance policies don’t typically contain cash value accounts, so this more fully applies to the types of life insurance that fall under permanent life insurance policies, such as whole life insurance.
With whole life insurance, your policy can have a cash value account that builds as two things occur:
- You pay your monthly/annual premiums, and a portion of your payments is put into the cash value account
- The money in your cash value account earns investment gains or interest over time
You can withdraw money from this account, and your withdrawals won’t be taxed if you only withdraw an amount equal to or less than what you’ve already put into the account in premium payments. Once you pass that amount, you’d be withdrawing from the investments or interest earned, which would count as taxable income.
You can also take a loan out against your policy. This loan will generally not count as taxable income unless you surrender your policy or the policy lapses. You surrender your policy when you cancel it, and it will lapse if you stop paying your premiums. A lapsed policy no longer provides you with coverage. In these cases, you would have to pay income taxes on the loan and any interest accrued.
6. When you have certain group life insurance
Employers often offer their employees options to enroll in group-term life insurance policies with little-to-no requirements and are typically free. Most of the time, we aren’t taxed on our work benefits, and that mostly holds true for life insurance.
According to the IRS in IRC section 79, there is an exclusion for “[T]he first $50,000 of group-term life insurance coverage provided under a policy carried directly or indirectly by an employer.” That means if your coverage exceeds $50,000 and is being subsidized by your employer, the excess cost of coverage could be counted as taxable income. The excess cost is called imputed income. Your employer would have to calculate the imputed income value and include it on your W-2 tax form each year.
7. If you earn interest on installment or delayed payments
In some cases, you may want your policy’s death benefit to be disbursed in installments to your beneficiaries. Or, you may request that it be held for a period of time before the funds are released.
Generally speaking, the original death benefit will still be non-taxable in this case. However, any interest earned on the balance while it’s held will be subject to taxes.
8. If you sell your policy to someone else
Some policy owners may want to sell their life insurance policy down the line as a way of generating cash or bypassing high monthly premiums. This sale, called a life settlement, usually offers more than the cash surrender value of the policy but less than the net death benefit.
If you choose to sell your policy through a life settlement, you are responsible for taxes on any proceeds beyond the policy’s basis. The IRS calculates taxes differently depending on the type of policy and whether it was sold or surrendered. However, you can generally expect to pay taxes on the difference between what you receive and the policy’s cash value, accounting for premiums paid and withdrawals taken.
Are life insurance premiums tax deductible?
No, life insurance premiums are not tax deductible. They are considered a personal expense by the IRS.
Are life insurance dividends taxable?
No, dividend payments themselves are not considered taxable income as long as you don’t receive more in dividends than you paid in premiums for that policy.
In general, you won’t have to worry about tax implications when it comes to your life insurance. The threshold on gift and estate tax is high enough that the average individual won’t ever cross it. Still, if your benefits are taxable, is life insurance worth it? In most cases, even if the life insurance benefits are taxed, the final sum will still be worth it to your beneficiaries.
If you’re shopping for life insurance, you can use a tool such as an online marketplace to compare life insurance quotes from the best life insurance companies. It’s quick, easy, and can save you money on a personalized policy. If you feel your situation is more complicated, you may also want to talk with a tax professional and/or a financial advisor.
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