Life insurance is essential for parents, guardians, and partners who want to leave a reliable source of income or sustenance for their loved ones. Ideally, you would like your life insurance benefits to be tax-exempted to ensure the beneficiaries receive the total compensation.
So, how do you do that?
According to the IRS, a beneficiary to a life insurance policy may have to pay taxes if their benefits accrued interest due to the insurance provider withholding the money for a set period. Alternatively, if the benefit is paid to an estate, the estate may have to pay taxes.
Here's a breakdown of taxation on life insurance policies and how you can make an exemption for your case.
The Different Types of Taxes You Can Pay on a Life Insurance Policy
The following are the different taxes applicable to a life insurance policy.
Income tax is the federal or state tax on your income. The IRS may take life insurance proceeds as part of your earnings and charge you accordingly based on your net income tax bracket.
This tax affects very few beneficiaries of life insurance. It's a state tax on inheritances paid by the heir. This tax only applies in six states. They include Iowa, Maryland, Kentucky, New Jersey, Nebraska, and Pennsylvania.
When someone dies, the federal government and some states add up the total value of their assets, including life insurance, subtract all outstanding debts, and tax the final figure. The estate pays the estate tax and not the heirs.
Recent legal changes have increased the number of estates unaffected by the estate tax. As of 2023, only estates valued at least $12.92 million must pay estate tax. Moreover, states that impose their estate tax typically do so for estates valued at least $1 million to $7.1 million.
This tax applies when an heir is not the immediate generation or descendant of the deceased or a "skip person," regardless of whether they're family. For instance, a grandfather may have his heir as his granddaughter, skipping his child.
The generation-skipping tax also applies to money a skip person inherits through a trust.
Cases Where the Life Insurance is Taxable
The death benefit of life insurance is typically tax-free. However, there are instances where life insurance payout can be subject to taxation. These scenarios include the following:
The Death Benefits are Part of Your Estate
If your death benefits are paid out to your estate, the estate tax will apply to the proceeds. The IRS will count the value of the payout in your estate regardless of whether you have a beneficiary or not. This payout can push the total taxable value of your estate over the limit, forcing your heirs to pay estate tax on assets above the threshold within nine months of your death.
If you have a will or trust, you can have the payout from the life insurance policy pay the estate taxes.
The Death Benefits are Issued in Installments
Insurance providers typically pay death benefits in lumpsum amounts. However, the beneficiary can choose to receive the benefits in installments, making them eligible for taxation.
When receiving the benefits in installments or annuity, the insurance provider withholds the principal amount in an interest-generating account, issuing a percentage of the benefits over a given period.
The accumulating interest is usually subject to income tax since it represents a steady income stream.
There are Three Different People in the Policy
The death benefits of your life insurance can be subject to gift tax if three different people fill each of the policy's three roles. These include:
The insured: The person covered by the life insurance policy
The policy owner: The person who owns or buys the policy
The beneficiary: The person receiving the death benefit when the insured dies
In most cases, only two people are involved in a life insurance policy. However, if a third person is included, each taking a unique role, the IRS treats the death benefit as a gift from the policy owner to the beneficiary.
Gift taxes are typically paid by the donor, in this case, the policy owner.
You've Sold Your Life Insurance Policy
Selling your life insurance to a third party often gains you more money than surrendering it. Also called a life settlement, the gains are typically higher because the policy's value is not capped at its cash value amount. Other factors such as life expectancy, cost of premiums, and death benefits help in appraisal.
The IRS levies income and capital gains tax when you sell your life insurance policy based on your profits. Income tax is based on the amount of cash value exceeding the policy basis, and capital gains tax is based on other sales profits, such as money received exceeding the policy's cash value.
You've Surrendered Your Life Insurance Policy
Surrendering a permanent life insurance policy means you're canceling coverage. In this scenario, the insurance provider pays the policy's cash value minus surrendering fees. The IRS taxes the portion of the cash value exceeding the policy's basis.
This taxable amount is the investment gains earned from the policy.
You've Taken a Loan Against the Cash Value
Cash value loans are typically tax-deferred even if the borrowed amount exceeds the policy's basis. Therefore, you can get tax-free loans against your life insurance policy if you repay them. However, defaulting can have severe tax implications.
If you default on a cash-value loan, the insurer will cancel your policy and use its cash value to repay it. You'll be required to pay tax for the amount exceeding the policy's basis, which often accumulates into a hefty bill.
Moreover, if you die before repaying the loan, your death benefit will cover the defaulted amount, meaning your beneficiaries will receive less money.
How to Avoid Taxation Using Irrevocable Life Insurance Trusts (ILIT)
An irrevocable life insurance trust (ILIT) is one of the most effective ways of tax-exempting death benefits from your life insurance policy. You must not be a trustee of the trust or have any rights to revoke it. Your policy must be held in the trust, meaning you've forfeited all ownership rights.
With this arrangement, the death benefits are not paid to your estate, exempting them from tax. Moreover, you maintain tighter legal control over the policy than transferring ownership to an individual.
Get Expert Advice
The IRS or states can tax death benefits from your life insurance policy in several ways. You must ensure you're fulfilling all legal requirements to give your beneficiaries the maximum possible payout from your policy. Contact a professional and learn how you can set up your policy.