Taxation on Life Insurance

Eric Van Haaften Estate Planning with Life Insurance

Understanding the taxation on life insurance is essential for sound financial planning.

Whether you’re a beginner or have an existing policy, it’s important to know: Is life insurance taxable?

Let’s dive in and uncover all there is to know about taxability related to life insurance coverage so you can make an informed decision for yourself and your family!

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Is life insurance taxable?
What are the tax traps when cashing out coverage?
How does life insurance affect estate and inheritance taxes?
How do you minimize life insurance taxation?
FAQs: Life Insurance Taxation

Is Life Insurance Taxable?

Are you curious about the tax implications of life insurance? Let’s clear up any confusion.

We’ll cover whether beneficiaries are taxed on their payout and if premiums can be deducted from taxable income.

Don’t worry. It’s not as complex as it seems! By the end, you will have a solid game plan for smoothly handling these financial considerations.

Are Life Insurance Proceeds Taxable?

One common question is whether level-term life and whole life insurance policies are taxable upon death.

Term and permanent life insurance offers a tax-free death benefit to the beneficiary.

This provides a financially efficient solution to ensure your family can maintain their lifestyle, settle outstanding mortgages or debts, and have the necessary resources in times of need.

However, there are a few exceptions to this rule. If beneficiaries receive the death benefit in installments instead of a lump sum, any interest earned may be subject to taxation.

Additionally, if ownership of the policy changes hands shortly before the original owner’s death, the payout may be taxable under the “transfer-for-value” rule.

It’s also important to note that estate taxes could come into play if the total assets, including life insurance payouts, exceed the exemption limits.

Is Life Insurance a Taxable Deduction?

When it comes to life insurance premiums, they are generally not tax-deductible for individuals unless they exceed 7.5% of their adjusted gross income and they choose to itemize deductions.

However, there is an exception for businesses that take out policies on key employees.

In this case, the premiums can be deducted as a business expense if the company is not directly or indirectly named as the beneficiary.

However, it’s important to note that if the purpose of your life insurance policy is to support your family in case of your death, the IRS will not consider these premiums as eligible for tax deduction, even if they are paid from your business account.

Tax Effect of Cashing in Life Insurance

Life insurance policies can provide a source of cash if needed. However, it’s necessary to understand if you pay taxes on life insurance when you cash out before making decisions.

The four main options for accessing your policy’s cash value are withdrawals, loans, surrendering, and selling your policy.

Before making any decisions regarding accessing your life insurance policy’s cash value, consult a financial advisor who can provide guidance based on your circumstances.

Taxation on Life Insurance Withdraws

The first option is to withdraw all the cash value from your policy, terminating your coverage.

According to Market Watch, withdrawals up to the total premiums paid into the policy are generally considered tax-free. This is known as the “cost basis.”

However, any amount withdrawn beyond this cost basis may be subject to taxes as taxable income.

Alternatively, you could make partial withdrawals from your policy’s cash balance while still keeping it active.

It’s crucial to check your policy details because early withdrawal penalties may apply, and any unpaid withdrawals will reduce the death benefit your beneficiaries receive.

Taxation on Life Insurance Loans

Another option is taking out a policy loan against your life insurance policy. The outstanding loan does not interrupt the compounding interest inside your policy.

It is non-taxable since it’s considered a personal loan between you and the insurer, with collateral being your policy’s cash value.

However, if the loan causes your policy to lapse, taxes may apply on its outstanding balance.

Policy loans come with fixed or variable interest rates, depending on the insurer issuing your policy.

While regular payments are recommended for maintaining the benefits and integrity of your policy, they aren’t mandatory.

If there’s an outstanding loan balance upon death, it will be deducted from the death benefit received by beneficiaries.

Taxation on Surrendering a Policy

The third option involves surrendering your life insurance policy for its cash value after canceling your coverage entirely.

It’s important to note that surrendering a policy means forfeiting any potential investment growth, dividends, or interest earned on the policy.

Surrender fees are subtracted from cash value when calculating your surrender value.

If you cash in an insurance policy, is it taxable? If you decide to cash in your policy and surrender it, any amount received above the total premiums paid will be considered ordinary income.

Any outstanding loans against the policy may also be subject to taxation.

Taxation Upon Selling a Policy

Life and viatical settlements offer a way to convert your life insurance policy into cash by selling it to an external investor.

In return for a lump sum payment, the investor takes over paying premiums and receiving the death benefit.

These settlement options differ depending on the policyholder’s age, health, and projected lifespan.

Life settlements are available to individuals who are typically 65 years or older and have more than two years of life expectancy.

The taxation of life settlements depends on factors such as the amount received and the policy’s cost basis, with income or capital gains tax applicable.

On the other hand, viatical settlements specifically cater to policyholders facing terminal or chronic illnesses that reduce their life expectancy to less than two years.

According to IRS guidelines, viatical settlements generally enjoy tax-free status if specific criteria regarding illness severity and sale conditions are met.

Estate Taxes and Inheritance Taxes

Estate planning involves preparing to administer and distribute a person’s assets upon death.

Understanding estate taxes and inheritance taxes can be complex and is often done with the assistance of an estate planning attorney.

Still, it’s important to unravel the differences between these terms when dealing with a deceased person’s assets, including life insurance payouts.

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Estate Tax: The Federal Implication

Let’s start with estate taxes. The federal government imposes an estate tax on your right to transfer property at the time of your death.

This tax applies to everything you own or have specific interests (your Gross Estate).

If your estate exceeds a specific value threshold, any amount over that limit may be subject to taxation before being distributed among beneficiaries.

For 2024, the federal estate tax threshold is set at $13.61 million for individuals and double for married couples at $27.22 million.

If your estate surpasses this threshold, you will generally pay a base tax plus a progressive rate ranging from 18% to 40%.

Life insurance policies are an effective method to cover estate taxes. The federal estate tax is levied on the total value of a deceased person’s assets and must be settled within five years.

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Inheritance Tax: State-Level Concerns

In contrast, inheritance taxes are assessed by some states on what heirs receive after someone dies.

Unlike estate taxes that come off the top before distribution, inheritance taxes depend on who inherits and their relationship with the deceased.

Only six states impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Each state has its rules regarding rates and exemptions for different categories of heirs.

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life insurance and taxes

It’s worth noting that life insurance payouts typically do not incur income taxes under most circumstances if you are named as a policy beneficiary.

However, there are exceptions based on factors such as larger estates or specific types of policies.

If a life insurance policy was included in the deceased person’s overall estate value, its value could potentially push the estate’s total value above the federal threshold for taxation purposes.

In this case, your inheritance might indirectly be affected by estate taxes.

One option to avoid paying taxes on life insurance proceeds altogether is transferring ownership of the policy to another individual or entity before passing away.

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Minimizing Life Insurance Taxation

Life insurance in estate planning is more than just preparing for the unexpected.

It’s like playing chess, where you anticipate future moves and use life insurance strategically to protect your assets and loved ones.

Developing strategies to minimize taxation on life insurance can save you money and safeguard your beneficiaries from unnecessary tax burdens.

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Transfer Ownership of Your Policy

One option is transferring the ownership of your policy to another individual, such as a spouse, child, or trust.

Doing so can avoid estate taxes on the death benefit since it will not be included in your taxable estate.

However, remember the three-year rule: if you pass away within three years of transferring the policy, the death benefit will be added back into your estate for tax purposes.

Additionally, ensure you understand how this transfer may impact the new owner and beneficiary regarding taxes.

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Set up an Irrevocable Life Insurance Trust

If you want to avoid taxes on life insurance proceeds, another alternative is establishing an irrevocable life insurance trust (ILIT) to manage and own your policy.

An ILIT is a legal entity capable of purchasing a new policy on your life or receiving a transferred one from you.

An ILIT typically pays premiums and distributes the proceeds of a survivorship life insurance policy according to predetermined trust terms.

Through an ILIT, you can remove the policy from your estate entirely while avoiding any associated estate taxes; furthermore, it grants more significant control over how proceeds are utilized.

However, creating and administering an ILIT necessitates careful planning and may incur legal and administrative fees.

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Generation-Skipping Transfer

Utilizing a generation-skipping transfer (GST) enables passing on your policy directly to grandchildren or individuals at least 37.5 years younger than yourself.

GSTs allow assets to bypass one generation during transfers—helping evade both estate and inheritance taxes for both children’s inheritances and grandchildren involved in this process.

Nevertheless, a limit exists regarding how much can be transferred through GST without being subject to GST tax.

Moreover, consider gift tax implications when considering whether to transfer policies directly or indirectly via trusts/beneficiaries subject to GST.

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Final thoughts

Understanding whether life insurance is taxable doesn’t have to be confusing. By breaking it down into simpler terms, we can see that it’s possible to navigate the complexities of tax regulations.

By employing these strategies, you can potentially minimize the taxation on your life insurance policy, ensuring that your loved ones receive the maximum benefit while reducing unnecessary financial burdens.

It is advisable to consult with a financial advisor or tax professional who can provide personalized guidance based on your specific circumstances and goals.

FAQs: Life Insurance Taxation

Is there a penalty for cashing out a life insurance policy? If you decide to cash out your life insurance policy, a surrender fee will typically be deducted from the amount you receive. This fee can vary depending on your policy.

Does a will or trust override a life insurance beneficiary? A will or trust does not supersede a life insurance beneficiary. The death benefit is paid directly to the named beneficiary on the policy, regardless of instructions in your will or trust.

Do you pay taxes on inherited life insurance funds? You are not required to pay taxes on money inherited from a life insurance policy. However, if the benefit earned any interest, you may be liable for taxes on that interest amount.

Is return-of-premium life insurance taxable? No, return-of-premium life insurance is not taxable. If you live beyond the policy term, you receive a refund of the premiums paid, which is considered a reimbursement rather than income.

Is group life insurance from my company deductible? While insurance premiums are generally not tax deductible, some portions of group life insurance premiums a company pays may be eligible for deduction.