Will You Pay Taxes On Life Insurance

is life insurance taxable

Death benefit proceeds from life insurance are customarily tax-free lump-sums of money paid out to your beneficiaries.

Unfortunately, there are times when they might be subject to taxation, such as when they exceed a specified threshold or when they’re paid out in installments.

The best way to ensure financial security is through a life insurance policy, which provides the means for beneficiaries to pay for things like a mortgage, college, and much more.  However, like lottery winnings, these large sums of money are subject to be taxed.  So, are all life insurance proceeds subject to taxation?  Not always.  Generally speaking, only permanent life insurance policies, like whole life, and large estates are subject to be taxed.

Taxes and The Life Insurance Death Benefit

As mentioned briefly above, life insurance death benefit proceeds are not subject to taxation.  The funds are usually distributed to your beneficiaries tax-free.  However, there will be times when taxes are applicable, such as in terms of estate size, incremental payouts, group life insurance, the selling of a policy, and cash-value policies.  Let’s take a closer look at each of these circumstances where taxation would be applied:

Estate Size and Estate Tax

Your estate could be subject to taxation if adding your death benefit results in your assets exceeding the estate tax threshold.  In order to prevent this from occurring, you would want to set up an irrevocable life insurance trust (ILIT), which allows for your death benefit to remain separate from your estate.  The death benefit proceeds are then distributed to your beneficiaries by the trust.  If you do gift a life insurance policy to the ILIT, it will need to be part of the ILIT for at least 3 years prior to your death, otherwise it will be included in your estate.

When working with irrevocable life insurance trusts, a term you will want to know is Crummey power.  This is a technique that allows a person to change a gift from one that is not eligible for a gift-tax exclusion to one that is eligible.  However, keep in mind that the gifted amount cannot be more than $12,000 annually per beneficiary.  Consult further, with a financial advisor, if this sounds of interest to you.

Lump-sums Versus Incremental Payouts

Life insurance death benefits are typically dispersed as a single lump-sum payment.  However, your beneficiary may elect to collect it in incremental payouts.  This works well by providing monthly payments to replace lost income, or if your beneficiary has difficulty being financially responsible with a large lump-sum distribution.

Keep in mind that if your beneficiary were to decide to utilize a monthly installment plan on your life insurance proceeds, interest will accrue on the total death benefit.  While your beneficiary won’t be subject to tax on the death benefit, they may be taxed on any interest gained.  This is an extra cost that your beneficiary may be not prepared for, making the lump-sum choice more prudent.

Group Life Insurance

Group life insurance is a benefit from an employer.  Most group policies are term life insurance with no medical exam requirement. While some employers may provide group life insurance, it’s usually not an adequate substitute for an existing individual policy because the coverage offered is significantly lower.  However, the coverage amount from group life insurance will play a part in taxation

If you do choose to receive life insurance coverage from your employer, and they are contributing to its cost, then coverage exceeding $50,000 will be regarded as income and taxed accordingly.  However, if the coverage amount is less than $50,000, then it will not be taxed.

When Selling a Life Insurance Policy

As the policyholder, you have the ability to sell the rights of your life insurance policy to another party.  However, as you will see with cash value policies, if you make a profit from selling your life insurance policy, the profit you earn will be taxed accordingly as earned income.

cash value life insurance

Cash Value Policies

Term life insurance policies are easier to deal with due to the fact that there’s only a death benefit to be concerned with.  However, permanent forms of life insurance, such as whole life insurance and indexed universal life insurance are more complex because of their cash value component.

Participating policies are cash value policies that distribute dividends, while non-participating policies, like term life insurance policies does not distribute any dividends.  According to the U.S. tax code, dividend payments are not taxed.

Unique to the cash value component of a policy, is that it either increases or decreases over the years.  A whole life insurance policy guarantees a minimum interest to be earned and the cash value grows tax deferred.  The amount paid into the policy is referred to as cash basis, and any withdrawals less than or equal to the cash basis is not taxable.  Conversely, withdrawals that are greater than the cash basis are subject to taxation.

Policyholders also have the ability to take out a loan against the cash value, and any loans not paid back in are considered taxable.  If policyholders of whole life insurance policies surrender their policy, any profit made is also subject to be taxed.

Taxes on Premiums and Return of Premiums

Unfortunately, life insurance premiums are not considered tax deductible, even if your life insurance policy is an individual policy.  Additionally, health savings accounts and flexible spending accounts cannot be used to pay your life insurance premiums.

Life insurance policies that allow all premiums paid in to be returned to the policyholder are called return of premium.  Normally, receiving large lump sums of money, such as lottery winnings, is subject to taxation.  Fortunately, return of premiums are tax-deferred because it’s the return of the money that you paid in and not considered a payment.

Life Insurance and Avoiding Taxes

Permanent forms of life insurance is appealing to those wishing to avoid taxation because of the fact that payouts, cash value gains, and life insurance dividends are not subject to income tax.  Additionally, combining life insurance with an irrevocable trust allows one to also avoid estate taxes.  Unfortunately, it’s those with a more substantial income that have the ability to afford permanent forms of life insurance.

 

life insurance policy genius

 

If this is something that you find appealing and practical, you can call Ogletree Financial at 1-800-712-8519 for some guidance.  We will be able to ensure that your policy is properly structured while producing the tax benefits needed to protect your loved ones after you die.