Is Money Acquired by a Life Insurance Payment Taxable?

Are life insurance benefits taxable? Normally, life insurance benefits are not taxable like ordinary income is. But there could be certain situations where you may have to pay tax on life insurance proceeds. 

In general, life insurance benefits are taxable if they exceed certain state and federal limits. In this case, they are considered as estate you are passing on to your heirs and taxed accordingly. 

Additionally, you may owe money to the taxman if you decide to surrender your policy or accept a settlement on your life insurance to dispose of it. You will have to pay capital gains and income taxes in such events. 

The information shown below pertains to situations where life insurance benefits may be taxable. Bear in mind that these are just general guidelines. Your own situation may vary from these scenarios. Thus, you should always consult with your accountant or financial advisor to find out how much you owe to the IRS on life insurance proceeds.

Are Life Insurance Benefits Taxable?

 

If proceeds from life insurance are given out in the form of a single payment, then such proceeds are usually not taxable as income. The situation is different if proceeds are paid out to beneficiaries in the form of installments. In such a case, your insurer will incur interest on the outstanding amount that is not yet paid out to beneficiaries. 

Life insurance policy holders may instruct their insurer to pay out benefits in the form of installments if the recipients are dependent on such income or if the beneficiaries are children. In such cases, beneficiaries will incur income tax.

Estate taxes are treated differently. In the event of your demise, the executor of the estate will have to file an estate tax return by submitting IRS Form 712. This form will have details on your life insurance benefits and its value when you passed away. If the beneficiary is your spouse, then there will be no tax on the proceeds, and they will receive the full amount of the benefits. They will also receive the full amount of the estate you left them. As far as estate taxes are concerned, there is no limit on the exemption for spouses.

If the insurance beneficiaries are not your spouse, then the life insurance proceeds are considered a part of your estate. This will happen if the beneficiaries are your parents or children. As long as your estate is within a certain state threshold, there will be no tax. But when it exceeds this limit, then tax must be paid. Thus, any benefits beyond the state limit will incur inheritance and estate taxes. 

Here are the limits and how much taxes are paid for amounts in excess of these limits.

Federal Estate Tax – if individuals receive over $11.58 million from your estate, then federal estate tax is applied at a rate of 40%. 

State Tax – inheritance and estate taxes are in force in 18 states and DC. Thus, the threshold amount varies between states. This limit varies between $1 million and $2 million. The tax rate will also vary according to your state rules. It can go up to 20% depending on the state you are residing in.

One important legal factor to bear in mind is that life insurance proceeds are treated as part of your estate from the point of view of taxation. Life insurance payout will not be treated as part of your estate when your creditors are paid. In fact, the only situations where life insurance benefits are considered a part of your estate is when your beneficiaries pass away, or you deem the estate to be the beneficiary. 

 

Irrevocable Life Insurance Trust for Avoiding Estate Taxes

 

You can establish a life insurance trust as a vehicle for legally avoiding estate taxes on life insurance payouts. To do that, you have to appoint the ILIT as the policy owner. You cannot be a trustee. You can assign anyone you like to act as the trust beneficiary. 

Although setting up an ILIT usually helps to avoid taxes on life insurance proceeds, there could be certain events where tax will be imposed on these proceeds.

When you are establishing the trust, the cash value of the life insurance policy must be less than a certain amount to avoid tax during ownership transfer. That is, when transferring policy ownership to the trust, the cash benefits must be under the gift tax limit for avoiding the gift tax. In 2020, the gift tax exemption stands at $15,000.

If you are deceased within 3 years of transferring life insurance policy ownership to the ILIT, then insurance benefits are treated as part of your estate. The purpose of this rule is to prevent tax avoidance by passing on assets in the form of deathbed gifts. 

 

Are Life Insurance Policy Living Benefits Taxable?

 

Certain life insurance policies provide you with the option of receiving some of its benefits if you are chronically or terminally ill. The major advantage of this option is that you receive benefits to pay for the high cost of medical treatment. 

If you receive a diagnosis for illness and choose to accelerate life insurance benefits, there are usually no taxes. From the point of view of taxation, accelerated benefits are seen as proceeds paid out to you, the insurance plan owner. That is, you are considered the beneficiary of the insurance policy with accelerated benefits. 

You should also know what happens when you pay premiums towards a permanent life insurance policy. Every time you pay your premium, part of this payment is added to the cash value. But what exactly is the cash value? It is basically the sum that will be paid out to you should you elect to surrender the policy to your insurance company. The cash value will grow according to the interest rate mentioned in the policy. The cash value is tax-deferred. 

You can also receive a loan tax-free from your insurer if you keep the cash value as collateral for the loan. Hence, the loan should not be in excess of the cash value. But if the loan is worth more than the cash value, then the loan will become taxable. 

 

Life Insurance Settlement Taxes

 

If your spouse has passed away and you don’t have kids, you may decide to go for a life insurance settlement since you don’t have much need for the policy. For this to happen, a third party must pay you a specific sum to become the beneficiary as well as the policy holder. Hence, the third party will pay premiums.

Under the transfer for value rule, the third party has to pay taxes on benefits when you are deceased. But income taxes are not incurred on the full value. The third party has to pay taxes on the benefits less the amount you received. This will also include premiums paid since they became the policy holder.

When you sell a life insurance policy, you will have to pay taxes much like a seller. Part of the life insurance settlement is taxed as income, while the remainder is subject to capital gains tax. 

 

Taxation on Surrendering Life Insurance

 

You could decide to surrender the life insurance policy, or it may be possible that you don’t receive a life insurance settlement. In both cases, the cash value of the policy decides how much tax you owe. You do not have to pay any tax if the cash value while surrendering is under the total amount that you paid as premiums. But if the cash value exceeds the total premiums paid, then you will owe tax on the difference. 

As there is no cash value associated with term life insurance, you won’t owe any taxes when you surrender the term policy. But that’s because you will not get any cash from your insurer.

 

Are Premiums Paid on Life Insurance Tax Deductible?

 

With individual insurance policies, premiums paid are not tax deductible. They are treated just like other expenses. 

However, this does not apply to group term life insurance policies. An association or an employer usually provides such policies. The employer is permitted to deduct up to $50,000 in premiums for each employee. This applies only if the employer is not a beneficiary. If you are a member of such an association or an employee, then the total amount paid on such a policy may be included in your taxable income. 

If you possess under $50,000 by way of supplemental or group term insurance, then you don’t owe any taxes. However, for coverage beyond $50,000, the IRS will determine the fair market value depending on your age. Premiums paid are subtracted from the market value determined, and the resultant amount is taxable income. 

 

What Taxes May Apply to Life Insurance Proceeds

 

You should be aware of the various kinds of taxes that may be applicable to life insurance proceeds. 

 

Income Tax

Income tax is one that most people are most familiar with. It is a state or federal tax imposed on married couples or individuals. Under this tax regime, you have to include earnings made during the year and deduct expenses that are permitted under IRS rules. The resultant amount is taxable income. You will then apply the tax rate for your income bracket to determine how much you owe the IRS.

 

Estate Tax

All assets of the deceased, including life insurance, annuities, investments and property, are added up to calculate estate taxes in some states and at the federal level. Whatever the deceased owed in terms of credit card bills, medical bills, and other loans are subtracted from the total assets that the deceased left behind. The remaining amount is subject to estate tax. In short, it is the total assets of the deceased minus amounts owed by the deceased. 

It is important to note that this tax applies to the estate, not the individuals who are due to inherit it. 

The good news is that the federal estate tax applies only if the amount of the estate is in excess of $11.4 million. In states that impose the estate tax, the exemption for the estate left behind by the deceased may range between $1 million and $11.4 million. You should check your state rules to find out the estate exempt amount if your state charges this tax.

 

Inheritance Tax

The inheritance tax may sound very much like the estate tax, but there is a key difference. Unlike the estate tax (which is imposed on the estate itself), the inheritance tax is imposed on individuals receiving the inheritance. Spouses are normally exempt from paying the inheritance tax. But domestic partners and children are taxed in certain states. Currently, the inheritance tax is applicable only in 6 states. You should check up to see if your state is included.

 

Generation-Skipping Tax

As the name implies, this tax is charged on estate distributed among people who are not close relatives. Such persons may be related to the deceased or even unrelated. 

 

Life Insurance Payout Taxes

The most important and simplest rule to remember is that there is no income tax on life insurance proceeds when they are paid in one installment. Thus, if the amount is paid out lump sum, no income tax is charged no matter how large the amount is. 

Likewise, no estate taxes are incurred when the payout is less than $11.4 million. This applies only if you have not mentioned a particular beneficiary. 

 

Conclusion

 

You now have an idea of the general rules that apply to taxes on life insurance benefits. However, each case is different and may thus have a different tax consequence. You should thus talk to your tax consultant, accountant, or financial advisor on how much tax you could possibly incur based on your specific scenario.