Usually, the death benefit of a life insurance policy is tax-free, but there are a few cases in which it could be taxable.
Life insurance can shield your loved ones from debt and provide them a bright financial future, but how much of the policy will they actually receive?
While your beneficiaries should receive the full amount of the policy, we’ll walk through some unlikely scenarios that could call for taxation.
But don’t worry, we’ll give you a few pointers to avoid them.
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It’s important to understand the types of taxes you might run into with life insurance, as well as ones you won’t:
- Income tax: Since a life insurance policy doesn’t count as taxable income in most cases, you aren’t likely to encounter any issues with income taxes.
- Estate tax: According to the IRS, if all of your assets minus your debt is over $11.58 million, the estate will be taxed, with a max rate of 40%.
- Inheritance tax: Only a handful of states utilize this tax, which calls for the taxation of individuals who receive an inheritance from a parent or domestic partner.
- Generation-skipping tax: If you meet the estate tax threshold and designate your estate to someone beyond your immediate descendants, like a grandchild, the estate is taxable.
- Gift tax: If you transfer your policy to a beneficiary in an attempt to bypass estate taxes, that amount will be susceptible to a federal gift tax.
Fortunately, you don’t have to study up on all of the IRS tax code to understand how it applies to life insurance.
You just need to understand Section 2042, which explains your life insurance is included in your estate if the proceeds are going to 1) your estate or 2) designated beneficiaries.
Most people don’t have to pay taxes on life insurance. This is because you pay your premiums with dollars which have already been taxed.
If any of the scenarios below match your situation, you can rest assured your policy’s benefits won’t be taxed.
Most life insurance policies are structured to provide the beneficiary with a one-time lump-sum payment when the policyholder passes away.
Regardless of the size of the policy, your beneficiary won’t be responsible for income taxes.
As long as your estate doesn’t exceed the IRS limit, the policy will not be taxed either.
Cash Value Growth
If you have permanent life insurance, the cash value component of your policy builds and accrues interest over time.
Any growth of the cash value of a permanent policy is tax free.
It would only be taxable when you access gains exceeded by the amount of premiums paid in over the life of the policy.
Cash Value Surrender
Whether a policy is too expensive or no longer necessary, you can surrender a permanent life insurance policy.
When you do this, you get a lump-sum payment for the total cash value component of the policy.
Again, you won’t have to pay capital gains taxes for any of the growth the account has seen, unless it exceeds your premiums.
Cash Value Withdrawal
One of the advantages of permanent life insurance is the ability to withdraw funds from the cash value account.
If you do take out a loan from the policy, those funds will not be liable for taxation.
Just note that failure to repay the loan will result in the use of the remaining cash value or death benefit to cover the remaining balance and interest, leaving your beneficiaries with less money.
Return of Premium Life Insurance
Return of premium life insurance refunds your premiums if you outlive your policy.
This type of coverage is more expensive than basic term life insurance, but you don’t have to worry about your premiums being taxed.
Aside from potential fees, you’ll receive the full amount of the premiums you paid into the policy.
A lot of the best life insurance providers are mutual companies, meaning they are owned by the policyholders.
Each year, policyholders may receive dividends from the company’s profits.
As long as these dividends aren’t greater than the amount you paid for premiums in the same year, they won’t be taxed.
Terminal Illness Riders
With an accelerated death benefit rider, you could receive the proceeds of your policy while you’re living with a qualifying terminal or chronic illness.
In this scenario, you essentially become the beneficiary of your policy, so the death benefit you receive is not subject to being taxed as income.
On the opposite end of the spectrum, here are a few less common reasons your life insurance might be taxable:
Payout in Installments
If the beneficiaries of a life insurance policy choose to be paid in installments, there may be responsibilities for taxes.
So you can see why lump-sum payments are the most common payout, with good reason.
If you opt for installments rather than a lump-sum, the cash value will continue to accrue interest, which will be taxed as income.
The most common reason for taxation is unlikely to affect the average family, as wealth CFO Chad Rixse explains,
“Your entire estate must be worth more than $11.58 million in 2020 in order for any estate tax to apply at all. As a result, the vast majority of Americans will never have to worry about tax consequences for their life insurance proceeds.”
If your estate does cross the estate tax threshold, you may be able to avoid taxes by setting up an irrevocable trust, which we’ll discuss more below.
Profit from a Settlement
If you sell your life insurance policy to a third party, called a life insurance settlement, transferring your premium payments and death benefit to them, you might have some taxes to pay.
Whether or not you have to pay taxes depends on how much you’ve accumulated in cash value and contributed to premiums.
If your profits from the sale exceed that amount, you will be responsible for taxes.
Profit from a Surrendered Policy
Again, taxation on a surrendered policy’s cash value is rare.
The amount of money in the cash value account would have to be larger than the sum of premiums paid into the policy, and you’d only pay taxes on the excess.
Likewise, if you have an unpaid loan from your policy at the time of a sell or surrender, any amount of the balance exceeding your premiums is taxable.
Group Life Insurance
If you enroll in a subsidized group life insurance policy through your job, there’s a chance it could come with taxes.
Any amount over $50,000 can be taxed as income.
Most group life policies max out at $50,000 or the employee’s salary, though, making this type of taxation less common.
Unfortunately, the IRS does not consider your life insurance contributions the same way it values something like your HSA contributions.
On that note, you can’t pay your premiums using a health savings account or flexible spending account.
Premiums cannot be deducted from your taxable income, regardless of whether you’re self-employed or have access to a group policy at work.
If your assets meet or exceed the estate tax threshold, there are a couple of ways you can avoid taxation of your policy.
To keep your life insurance separate from your estate, you can transfer it to another adult or entity, with proper documentation from your provider.
The new policy owner is often the beneficiary. Once they assume ownership, they are responsible for making premium payments.
They also receive the right to make changes to the policy.
If you’d like to maintain a bit more control of your policy and ensure the premiums stay up-to-date, your best option is to place the policy in an irrevocable trust.
You lose ownership of the policy irrevocably, meaning it is no longer included in your taxable estate.
These trusts are ideal if you name your minor child or grandchild as a beneficiary, letting you pick a loved one to protect them as the policy’s trustee.
If you’re interested in a trust or policy transfer, a financial advisor can help you walk through the ins and outs of legally bypassing taxes on your policy.
Thankfully, most people won’t ever have to worry about paying taxes on life insurance.
It’s structured to provide your loved ones with full financial security, and you with peace of mind.
Regardless of the size of your estate, life insurance is an essential purchase if anyone depends on your income or could be held responsible for your debt.
Start comparing options today to find a tax-advantaged policy that meets your family’s needs.