Understanding the taxes on life insurance can be complex. It’s vital for policyholders and beneficiaries to inform of when and how taxes apply to their policies.
Life Insurance Tax Types
To ensure the protection of your life insurance policy and to understand potential tax implications, it is crucial to be aware of the various types of taxes that could affect life insurance payouts:
- Estate Tax: This tax pertains to the transfer of property posthumously. If the value of an estate, inclusive of life insurance proceeds, surpasses the federally established exemption limit, it may incur estate taxes.
- Inheritance Tax: Unlike the estate tax, levied on the deceased’s estate, the inheritance tax is charged to the beneficiaries receiving the assets. Only a few states—Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania—currently impose this tax on inherited life insurance proceeds.
- Income Tax: Typically, life insurance payouts are exempt from income tax, meaning that beneficiaries do not have to report the proceeds as taxable income when filing their annual tax returns.
- Generation-Skipping Tax: This tax is similar to the estate tax in that it applies to transfers of assets that bypass a generation. The generation-skipping tax triggers when transfers exceed a certain exemption threshold, mirroring that of the estate tax.
When Do You Pay Taxes on Life Insurance?
Taxes on life insurance are typically not a concern, but there are exceptions. If the cash value of your policy is substantial, you might have to deal with estate tax or generation-skipping tax. Also, if you’re a resident of Iowa, Kentucky, Nebraska, New Jersey, Maryland, or Pennsylvania, you could be subject to inheritance tax. Remember, each state sets its own rules for life insurance taxation.
When a Third Party is Involved
Most of the time, the person who owns the policy is also the one whose life is insured. In this case, there’s no tax. But if someone else is the beneficiary, like a father who gets the payout from a policy his wife bought for their daughter, then the father might have to pay taxes.
Withdrawing from a Cash Value Policy
If your life insurance has a cash value component, you might decide to borrow from it or make a withdrawal. Borrowing means you might face interest payments and a smaller benefit amount later. Withdrawing some of the cash value could mean saying goodbye to the policy unless you just take out less than what you’ve paid in. Under those circumstances, you wouldn’t face taxes.
Selling Your Policy
When you sell your policy, the person helping you sell it, like a broker, usually gets a cut. If you end up making more money from the sale than what you’ve paid in premiums, you could tax on the profit.
For Those With Terminal Illness
People who are terminally ill can sell their life insurance through something called a viatical settlement and often don’t have to pay taxes on it. This depends on how much the policy sells for versus what’s been paid in.
Surrendering Your Policy
If you decide to give up your policy, there could be fees, and you’ll likely have to pay taxes on the cash value.
When Life Insurance is Part of a Taxable Estate
If you don’t name a specific person as the beneficiary, your life insurance might just become part of your estate when you die. There’s a big tax exemption here—up to $11.7 million at the federal level. But anything above that could be taxed. States have their own rules and often lower exemptions.
Is Life Insurance Tax Deductible?
Life insurance premiums are generally not tax deductible because they’re seen as a personal expense. Yet, life insurance does come with tax advantages. If you own a business and the business pays the premiums, those can be deductible. Moreover, the cash value in your policy grows tax-deferred. This means you don’t pay taxes on the growth as it happens, allowing your money to grow more due to higher interest rates without immediate tax cuts.
Tips to Avoid a Life Insurance Benefit Tax
Using an Ownership Transfer to Avoid Taxation
Most estates won’t have to pay federal taxes, as the exemption limit is $12.06 million for those who passed away in 2022 and will rise to $12.92 million in 2023. The maximum tax rate is 40%. These higher limits set by the Tax Cuts and Jobs Act will end after 2025 unless Congress decides to keep them.
If your estate does have to pay taxes, whether life insurance proceeds are taxable depends on who owns the policy when you die. To keep the life insurance out of your taxable estate, you might need to give the policy to someone else or a different entity.
Keep these points in mind if you’re thinking about changing the policy’s ownership:
- Pick a reliable adult or entity as the new owner—often the person who will get the payout—and contact your insurance company to get and fill out the forms needed for the ownership switch.
- The new owner will need to pay the insurance premiums, but you can help by giving them a tax-free gift of up to $16,000 in 2022 or $17,000 in 2023, which they could use towards the premiums.
- Once you transfer ownership, you can’t make decisions about the policy anymore. But if you pass it to a child, other family member, or a friend, they can make changes you suggest.
- Think carefully before transferring ownership in case of a divorce, because it’s a final decision.
- Get a written confirmation of the change from your insurance company to prove it’s been done.
If the insured person, the owner of the policy, and the person who gets the money after death are all different, the IRS might treat the payout as a gift. This could lead to gift taxes. Normally, the person the insurance covers also owns the policy. But if not, and the policy is seen as a gift to the beneficiary, gift taxes might come into play on the payout.
If you pass away, any gift taxes on that money would be due then. But the person receiving the money, the beneficiary, only needs to worry if what they get from you, including any other gifts above $17,000 per year, goes over $12.92 million in 2023.
If you give someone your insurance policy and die within three years, it’s as though you still own the policy. This means it’s part of your estate for tax purposes.
To avoid this, an irrevocable life insurance trust (ILIT) can be used. If you set up an ILIT, you can’t be in charge or cancel the trust. Once in the trust, the insurance isn’t seen as yours anymore, and it won’t be part of your estate.
Why choose a trust over simply giving the policy to someone else? Perhaps you want to keep some control, or you’re worried the new owner might not pay the premiums. A trust can make sure payments are made. Plus, if the insurance money is for minor children, maybe from an earlier marriage, a trust allows you to pick someone you trust to look after the money for them according to the trust’s rules.
Regulations on Life Insurance Policy Ownership
The IRS determines the owner of a life insurance policy when the insured person passes away. The main rule to remember is the three-year rule: if you transfer your life insurance policy to someone else, or to an irrevocable life insurance trust, less than three years before you die, it will still count towards your estate for federal estate tax purposes.
When you hand over a policy, you must relinquish all rights to it. This means you can’t change the beneficiary, take out a loan against it, cancel it, or decide how the beneficiary uses the money. You also must stop paying the premiums. If you keep any control or continue paying premiums, you might lose the tax advantages of the transfer.
However, even if you properly transfer a policy, taxes may still be due. If the policy’s value exceeds the annual gift tax exemption—$16,000 for 2022 or $17,000 for 2023—gift taxes may apply at the time of the giver’s death.
Do You Have to Pay Taxes on Money Received as a Beneficiary?
As a beneficiary, you usually don’t need to pay taxes on the money you receive from a life insurance policy.
Do You Pay Taxes on Inherited Life Insurance Money?
You typically don’t owe taxes on life insurance money you inherit. However, if the benefit earns interest before you receive it, you might need to pay taxes on that interest.
How Do I Avoid Taxes on Life Insurance Proceeds?
Usually, you don’t have to pay estate or income tax on life insurance proceeds. If your life insurance payout gains interest before you get it, you can cut down on the taxes for that interest by properly managing and quickly turning in the required forms.
Do I Need to Report Inheritance to the IRS?
Generally, you don’t have to report an inheritance to the IRS. However, any earnings on the inherited assets that you receive afterwards may be subject to tax.
The Bottom Line
Many people have life insurance policies with death benefits ranging from $500,000 to several million dollars. When you include the worth of your house, retirement funds, savings, and other possessions, your estate’s total value might be unexpectedly large. With additional years for potential growth, you could end up with an estate large enough to have tax implications.