Are Life Insurance Proceeds Taxable?
There is an old idiom that says something to the effect that the only thing certain in life is death and taxes. The good news is, life insurance allows you to avoid taxes in death.
Take note, however, that the key to avoiding taxes on life insurance proceeds is to plan ahead, which starts with proper estate planning with life insurance.
In the following article we help provide you with the information in order to help you avoid taxes on your life insurance proceeds.
Everyone interested in life insurance wants to know is life insurance taxable? Normally a beneficiary of the proceeds will not have to pay taxes on the life insurance death benefit payout. The saying goes, the best things in life are free. While that might not always be true, it is good to know that some of the best things in life really are free.
Now, while the premiums on your life insurance are certainly not free, generally the death benefit on your life insurance is not taxable to your beneficiary.
26 U.S. Code § 101 – Certain death benefits
(a) Proceeds of life insurance contracts payable by reason of death
(1) General rule. Except as otherwise provided … gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.
(g) Treatment of certain accelerated death benefits
(1) In general. For purposes of this section, the following amounts shall be treated as an amount paid by reason of the death of an insured: (A) Any amount received under a life insurance contract on the life of an insured who is a terminally ill individual. (B) Any amount received under a life insurance contract on the life of an insured who is a chronically ill individual.
According to the two provisions in IRC Section 101 above, neither the life insurance death benefit nor certain accelerated death benefits are taxed.
For clarification, that means that life insurance benefits are not taxed if the insured dies but also if the insured receives benefits for chronic or terminal illness. Further, section 101 of the code applies to both term life and permanent life insurance.
After IRC Section 101, we need to look at…
26 U.S. Code § 7702 – Life insurance contract defined
Under IRC Section 7702, the rules which determine rather a policy is considered a life insurance contract, as opposed to a Modified Endowment Contract, are set forth. If the policy is considered a life insurance contract, meaning cash value life insurance, then the policy will qualify for the tax advantages set forth in the code.
The reason we are differentiating here between term life and cash value life insurance is because the tax advantages in IRC Section 7702 are primarily for cash value life insurance.
After IRC Section 7702 we need to look at 26 U.S. Code § 803 – Life insurance gross income.
26 U.S. Code § 803 – Life insurance gross income
IRS code section 803 reads in part: (2) Policyholder dividends excluded from return premiums For purposes of subsection (a)(1)(B)—(A) In general…the term “return premiums” does not include any policyholder dividends.
Under IRS code section 803, life insurance dividends are not taxable. In other words, dividend payouts to participating whole life insurance is not taxable, making whole life a fantastic savings vehicle, particularly when used in conjunction with infinite banking.
5 Examples where life insurance proceeds are typically safe from being taxed
- When your life insurance policy names a specific beneficiary, such as your spouse or kids.
- When your life insurance policy is owned by an ILIT.
- Cash value withdrawals equal to the cost basis, (i.e. money you paid in to the policy), are not taxable.
- Dividends received on cash value life insurance are not taxable.
- Policy loans from a cash value whole life insurance policy are not taxable.
However, there are instances when life insurance is taxed.
Below, we address these instances and help shed some light on how you can avoid having your life insurance beneficiaries taxed on the proceeds.
Is life insurance tax deductible?
A popular question that seems to go hand in hand with is life insurance taxed has to do with whether or not life insurance premiums are deductible. As much as we wish life insurance premiums were tax deductible, the reality is premiums on individual life insurance policies are not eligible for deductions on your income taxes.
However, the good news for business owners is that premiums on key man insurance paid by an employer may be deducted by the company if the premiums are charged to the insured as taxable income. Source.
Note: The employee’s life insurance premium may be taxable. The work around is that a business utilizing key person insurance may pay an employee additional income to cover the taxes on the life insurance premium paid by the employer.
When Life Insurance is Taxable
Typically, a life insurance payout is taxable in the following 5 occurrences:
- Transferring the policy for valuable consideration.
- When you withdraw cash value above your cost basis.
- When you violate the rules of an ILIT.
- When your estate exceeds your federal death tax exemption. If life insurance is part of your estate it may be taxed. Also, be aware that some states also have an inheritance tax.
- When you beneficiary elects to take his or her payout over a period of time, rather than as a lump sum. Note: the death benefit is not taxed but any interest that accrues with the life insurance company may be taxed.
- When your original policy lacked an insurable interest based on what your state law defines it as.
Withdrawing Cash Value From Your Policy
As mentioned above, the cash value in your policy is not taxable up to your cost basis.
However, you will be taxed if you withdraw cash above and beyond your cost basis, i.e. the amount of premiums you paid into the policy.
All interest received on life insurance is taxable. Source.
Further, your cash surrender value may be taxable. If you choose to surrender your life insurance policy for cash value you will typically be taxed the difference between any proceeds received and the cost of the life insurance policy.
Pro Tip: Rather than withdraw from your policy, the best method would be to take out a policy loan on cash value. The life insurance loan is not taxable as income. Further, by choosing a non direct recognition mutual company, the cash value will continue to accrue interest and dividends on the total cash value, regardless of the policy loan.
When you Violate the Rules of an ILIT
Sometimes the best thought out estate planning can still lead to disaster. Take the irrevocable life insurance trust for example.
One of the key requirements of an ILIT is that the grantor of the trust avoid incidents of ownership. If this requirement is not strictly followed, the life insurance trust assets will be included in the insured’s taxable estate.
This is obviously a big deal because the main reason someone sets up an ILIT is to avoid having the insurance proceeds included in his or her estate.
Which leads us to one of the main reason life insurance is taxed.
ILIT 3 Year Rule
If the policy was transferred to an ILIT, three years must pass before an irrevocable life insurance trust can effectively avoid having the policy proceeds included as part of the estate.
If there was life insurance in effect, the executor must obtain a filled-out copy of IRS Form 712 from the insurance company. If there were multiple policies in effect, the executor must get a separate Form 712 for each policy.
The insurer uses this form to report details about the policy, including who owned it and the value at the time of death.
The insurer also must specify whether the deceased previously had owned the policy, but transferred it to another person less than three years before death. If so, the benefits will still be considered part of the estate.
This rule is designed to prevent “death-bed transfers” intended solely to avoid estate tax.
Exceeding the Federal Death Tax Exemption
Another primary reason for taxes on life insurance is when a person dies and their estate is valued above the federal exemption limit. For an estate to have to pay a federal estate tax or “death” tax the estate must be over the current 2017 federal estate tax exemption limit of $5,490,000 or $10,980,000 for a married couple.
Most people do not have to worry about taxes on life insurance because their overall estate is below the current federal estate tax exemption limit. There is much talk about the federal estate tax being repealed. But know that the exemption limit was as low as $1,000,000 just 15 years ago.
Further, consider this example. Suppose you had assets of $3,500,000. In addition, you also had a life insurance policy worth $3,000,000. Upon death your estate would be valued at $6,500,000.
That is $1,010,000 above the 2017 federal estate tax exemption limit. In this instance, your life insurance would be taxed as part of your estate since the proceeds from your policy bumped you above the exemption limit.
And the federal tax rate on life insurance in your estate is steep — currently 40%!!! That means that on a $6,500,000 estate, the taxes on life insurance that bumped you over the $5,490,000 maximum would be $440,000!
State Death or Inheritance Tax
Another way that life insurance could be taxed is if you live in a state that has an inheritance tax. Currently, 21 states and the District of Colombia have a state inheritance tax or estate tax. Source.
The state inheritance tax exemption varies but in some cases it is as low as $1,000. That means taxes on life insurance are guaranteed in certain states, although the tax rate is lower than the federal level of 40%. The highest state death tax is 20% in Washington State.
A Living Trust does not protect against taxes
It is important to know that naming your revocable trust or your family trust as the beneficiary of your life insurance will not avoid state and federal estate tax. Any assets above the state and federal exemption levels will be taxable, including your life insurance in your revocable trust. Therefore, for larger estates, placing your life insurance into an irrevocable life insurance trust is the best way to avoid taxes on your life insurance.
When your Beneficiary Forgoes the Lump Sum Option
When the policy owner dies, the life insurance beneficiary has options on how he or she receives the death benefit payout.
If the beneficiary elects to receive the payment other than as a lump sum, the interest earned on the life insurance is taxable as income. In other words, if the beneficiary elects to receive the death benefit payments in installments, the amount he or she receives over and above the death benefit will be taxed. Source.
For example, on a death benefit of $100,000, if your beneficiary chooses to take the death benefit in the form of monthly installments of $1,000 over a 10 year period instead of a lump sum, the amount above the $100,000 life insurance proceeds will be taxed.
In this example, $1,000 a month for 10 years amounts to $120,000. That means over the ten year installment period, your beneficiary will pay income tax on $20,000 of life insurance proceeds. This tax is assessed on the excess paid over the amount held by the insurance company divided by the number of installments to be paid ($20,000/120). In this example, your beneficiary will be taxed on income of $166 a month.
No Insurable Interest
If you went against public policy when the life insurance contract was created and you did not have a true insurable interest then you can run into all sorts of issues, including not being able to qualify for life insurance tax benefit protections under the internal revenue code.
When Life Insurance Benefits are Taxed [More Examples]
Life insurance benefits are taxed in the following two examples:
Group Term Life Insurance is excluded from any tax consequence if the total amount does not exceed $50,000. On coverage that exceeds $50,000, the “imputed cost of coverage” must be included in the employee’s income. Source.
However, this article is focused on if life insurance death benefits are taxable. The death benefit from employer based life insurance is not taxable, unless other factors come into play as mentioned below.
Life insurance as part of an estate will be taxed if the estate is valued above the current federal estate tax exemption. If you believe your estate will be taxed, consider an ILIT.
IRS Form 712
For trustees or executors of estates that have life insurance, the IRS requires that IRS form 712 be submitted with the estate tax return. IRS form 712 is filled out by the insurance carrier; it contains details such as who owned the policy and the value at the time of death. Also, the insured must specify if the decedent owned the policy but transferred it away. Be vigilant, this form may be the reason your life insurance is taxed.
Take the Next Steps
Now that you know life insurance is typically not taxed, isn’t it about time you began the process of becoming insured?
At TermLife2Go, we work with the top fully underwritten and no exam life insurance companies. Our job is to pair each client up with the company that best fills the unique health and lifestyle niche of our client.
Give us a call today and experience the TermLife2Go difference!
Thank you for reading our article, Death and Taxes: How Life Insurance Can Avoid Taxes. Please leave any questions or comments below.
This information is designed to provide a general overview with regard to the subject matter covered and is not state specific. The authors, publisher and host are not providing legal, accounting, or specific advice to your situation.
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