Life insurance, including death benefits, is usually not taxable since it isn’t considered taxable income.
However, there are situations when money from a tax benefit may get taxed.
Experts say people need to understand that life insurance is an asset.
“Unfortunately, everybody views it as an expense, which of course it is what is meant to cover a deficiency in a family’s otherwise careful planning,” said Bob Maloney, chief listener, Squam Lakes Financial. “Life insurance creates instantaneous cash that is nontaxable to the beneficiary and available to generate income in the future. It is a necessary evil in most financial planning situations and must be taken seriously. It provides not only financial security but a very high level of psychological security to the family.”
The first thing you need to do is name a beneficiary.
“It’s important to remember that life insurance is a private contract between you and the insurance company,” said John W. Seltzer, CLU, AVP, Engle-Hambright & Davies, Inc., who has been in the insurance business since 1984. “As a result, you always want to name a specific beneficiary, whether it is a person or a trust. When naming your estate or will as the beneficiary, it subjects the proceeds to any claims against your estate, whether they are from creditors or disgruntled heirs.”
Now, let’s take a look at when life insurance is or isn’t taxable, circumstances related to your taxes and life insurance.
When is life insurance not taxable?
Life insurance is almost always not taxable. A life insurance payout isn’t considered gross income. Therefore, it’s not taxable.
The IRS spells it out: “Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren’t includable in gross income and you don’t have to report them.”
Life insurance premiums also aren’t taxed or tax deductible. An employer can deduct group life insurance premiums, but not the employee.
In terms of the IRS, paying a life insurance premium is like other personal expenses. It’s no different than purchasing a new car or cell phone.
There are several instances when you’ll receive a life insurance benefit payout and not have to worry about taxes:
A death benefit payout in one lump sum
This is the typical life insurance payout. There aren’t taxes involved with it. Even if the death benefit goes to an estate when there’s no beneficiary, there’s not an estate tax unless it’s above a specific limit.
A gain in cash value to a beneficiary
A permanent life insurance plan provides cash value. In that way, the policy is a savings account. Despite getting gains on the value, you don’t pay taxes on it.
There is an exception.
“If you cash in the policy and there is cash value in excess of the premiums you paid in, there is a taxable gain,” Seltzer said.
Partial withdrawal from your policy’s cash value
You can withdraw part of a policy’s cash value portion while you’re still alive. If you do that, the amount isn’t taxable. However, you’ve got to pay it back before your death or the amount is subtracted from the death benefit.
Surrendering your policy
If you decide to ditch your current permanent life insurance policy for a new term life insurance policy, you may have built up cash value in that original policy. When you surrender that policy, the company will pay a lump sum. There won’t be taxes on that usually.
If you’re a mutual insurance company policyholder, you sometimes get money back annually in the form of dividends. Guess what? They’re not taxable, either.
“You can withdraw dividends,” said Seltzer. “Generally, dividends in a life insurance policy are not taxable. However, if your dividends are earning interest, that interest is taxable.”
Accelerating your death benefit
Accelerated death benefits, which aren’t taxable, basically lets you tap into the policy if you become chronically or terminally ill. You don’t get taxed for taking out that money.
“One of the unique features of life insurance is that the increases in cash value are not taxable,” said Seltzer, “making it a good accumulation vehicle. You can also sell a life insurance policy. However, any profit is taxable. Life Insurance generally avoids inheritance taxes and ‘generation skipping’ taxes when there is a named beneficiary. You need to check with your specific state.”
When is life insurance taxable?
Interest is taxable and needs to be reported on your taxes.
In some cases, when cash value is removed from a life insurance policy, it can become taxable if that policy is determined to be a modified endowment contract, Sanchez said.
“If the policy was determined to be a modified endowment contract where too much premium was paid into the policy in the first seven years,” said Seltzer, “then any withdraws from the policy’s cash value are taxable.”
“All insurance is required to pay interest on the death proceeds from the date of death until such time as the check is sent to the beneficiary,” said Maloney. “Although the proceeds from the face amount of the policy is not taxable, the interest earned during that period after death is taxable.”
As we mentioned earlier, you’ll have a taxable gain if you cash in a life insurance policy and there is a cash value that is bigger than the premiums you paid.
Another example of taxable life insurance interest would be a mutual insurance company-issued policy issued.
“If a person elected to leave their dividends in the policy to accumulate at interest, then the interest is taxable,” said Seltzer.
If there is a delay in paying the policy death benefit, the life insurance beneficiary’s payout would be taxable, too. In this case, the insurance company frequently pays you the interest in addition to the death benefit, making that interest taxable.
“Finally, if a policy was considered to fall under the ‘Unholy Trinity,’ then the death benefit would be taxable,” said Seltzer.
The Unholy Trinity refers to when the policy owner, insured and beneficiary are three different people or entities. Simply put, this “gift tax” causes the life insurance to become taxable.
The tax trap is also known as the “Goodman Triangle” after a 1946 court case, Goodman v. Commissioner of the Internal Revenue Service.
There are three points to this triangle:
- The policy owner — The person who bought the policy and pays the premiums.
- The insured — The person whose life the policy covers.
- The beneficiary — The person designated to receive the death benefit when the insured dies.
You should always try to make sure that two points of the triangle are the same person, charity or company. Otherwise, the death benefit counts as a taxable gift to the beneficiary.
“If, in fact, there are three different parties, there is going to be a gift at the moment of death,” said Maloney. “However, gift taxes are not taxable up to the lifetime exclusion, which currently stands at $11,400,000. As an example, I am the insured, my wife Bonnie is the owner and she names her son the beneficiary of the policy. Since she is the owner of the policy, at the split-second of my death, she has just made a gift to my son, the third party to the contract. As stated, there are gift taxes but no income taxes other than the interest earned after death.”
How can an irrevocable trust help with taxes?
When you create an irrevocable trust, it transfers all of the assets’ ownership into that trust. The terms can’t be modified, terminated or amended unless the beneficiary grants permission.
A major reason people set up these trusts relates to taxes and estates. When you transfer property into an irrevocable trust, it doesn’t add to the estate’s value. So, the IRS can’t tax the estate’s value.
“An irrevocable trust removes the life insurance proceeds from the insured’s estate; therefore, removing the estate tax liability,” said Seltzer. “It can also give greater control over the policy and its proceeds. It is a more private way to direct what happens with their life insurance proceeds after death. Wills and probate are public records. Most often, these trusts are set up to avoid estate taxes.”
Seltzer said that the ideal way to set up an irrevocable trust is to establish the trust first. Then, have the trust apply for, and be the owner of, the life insurance.
“Otherwise, if you transfer the policy to the trust at a later date,” said Seltzer, “there is a three-year look-back provision that includes the proceeds in your estate within the first three years after the transfer.”
In 2020, only estates above $11.58 million are subject to estate taxes.
The IRS said, “Beginning January 1, 2011, estates of decedents survived by a spouse may elect to pass any of the decedent’s unused exemption to the surviving spouse. This election is made on a timely filed estate tax return for the decedent with a surviving spouse. Note that simplified valuation provisions apply for those estates without a filing requirement absent the portability election.”
Maloney reiterates that if an irrevocable trust is the purchaser and owner of the policy on the life of the insured, they aren’t part of the taxable estate when the proceeds are received at the time of death.
“If, on the other hand, a life insurance policy is transferred to an irrevocable trust,” he added, “then for the estate tax exclusion to be effective, the trust must’ve been on the policy for a period of three years prior to the death of the insured.”
The good news is that you usually don’t have to pay taxes when it comes to life insurance. However, make sure you follow the proper steps so you don’t wind up not maximizing your death benefit.