In most cases, the proceeds from your life insurance won’t be taxed – but there are some exceptions.
One of the main selling points of life insurance is that the proceeds are typically not taxable. There are a few situations where beneficiaries will have to pay tax – and they usually apply to permanent policies or policyholders with large estates.
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When won’t the proceeds of your life insurance policy be taxed?
Generally, your beneficiaries can dodge taxes in these situations:
Payouts to beneficiaries
Most people buy life insurance so they can leave money to their beneficiaries when they die. Fortunately, the death benefit isn’t considered taxable income, so the full payout will go to your beneficiaries. There’s one exception (which we’ll explore in more detail below), and that’s when your estate is valued at more than $11.4 million.
Cash value gains
If you choose a permanent whole or universal life insurance policy, it often comes with a cash value benefit that accumulates over time. The cash value gains are not subject to any taxation unless the policy is surrendered or transferred to another owner — a scenario referred to as a life insurance settlement.
Should you decide to cancel your life insurance policy before it matures, you’re eligible to gain access to your accrued cash value, less any surrender fees.
Called a life insurance surrender, as long as your settlement amount is less than the total you paid in premiums, your surrender payout is tax-free.
Early payout for chronic or terminal illness
Many permanent life insurance policies offer riders or add-ons that cover unexpected chronic or terminal illness. These riders generally allow for an early payout of your death benefit to cover the medical costs, long-term care and everyday expenses that come with illness.
Generally, the IRS defines payout on such riders as an “acceleration of death benefits,” protecting them from taxation.
Annual life insurance dividends
Some big-name providers like Liberty Mutual, State Farm and New York Life are mutual insurance companies, which means they’re owned in part by their policyholders. (This is as opposed to stock insurance companies, which are designed for profit to stockholders.)
Policyholders with these companies are eligible to receive annual dividends on the company’s profits. Considered a “return of premium,” these dividends are not taxable as long as your received dividend amount is not more than the sum of your premium payments in the same year.
Scenarios when life insurance is taxable
Though life insurance has many tax benefits, there are a few situations when the proceeds of your policy will be taxed.
With so much riding on your life insurance, speak with a licensed accountant if you’re still unsure about the tax implications of your specific policy.
Interest earned on payout benefits
After you die, your life insurance beneficiaries often can choose to receive your policy’s death benefit as a lump sum or in installments over time. If they choose installments, the policy’s insurer holds the death benefit, which may accrue interest, depending on the account it’s held in.
In this case, the benefit’s principal avoids taxation, but any interest earned on it does not. So if your $250,000 life insurance benefit gains $25,000 in interest between time of your death and payout, your beneficiaries would likely owe taxes on the accrued $25,000.
Profit from surrendering a cash value policy
If you cancel before maturity a life insurance policy that includes a cash value, that cash surrender value is likely subject to taxation if it’s higher than the sum of your premium payments.
Say you’ve paid $8,000 in premiums annually over the 15 years you’ve owned your policy — a total of $120,000 over that time — allowing your policy’s cash value to grow to $150,000. If you cancel your policy, you’ll likely owe taxes on the $30,000 you’ve earned.
Unpaid loans against your policy
After a stated period of time, many permanent life insurance providers allow you to borrow from any cash value benefit you’ve accrued. Like most loans, you’re required to repay that loan with interest.
If you allow a policy to lapse or you cancel it outright before you’ve repaid your loan, you’ll owe taxes on the outstanding balance beyond what you paid into the policy.
Estate taxes on life insurance payouts
If your estate is valued at $11.4 million – the IRS threshold for 2019 – or more, it will be subject to federal estate tax. This applies to the life insurance payout, too.
To avoid this tax, consider transferring the policy to an irrevocable life insurance trust (ILIT). This will stop the proceeds from your policy from being counted as part of your estate. Just keep in mind that if you transfer the policy less than three years before your death, it might still be subject to the estate tax.
Note that the IRS offers an unlimited marital deduction that allows you to transfer unlimited assets to your spouse, free of any estate or gift taxes.
What is the unlimited marital deduction?
The unlimited marital deduction is a provision in the federal Estate and Gift Tax Law that allows you to pass assets totaling any amount to your spouse during your lifetime or after your death as part of your will or trusts — free from both estate and gift taxes.
Eligibility requires both you and your spouse to be US citizens, however.
Generation-skipping transfer tax
Generally, life insurance payouts to your spouse and children are not taxed. But what if your designated beneficiary isn’t a relative? In that case, your payout could be subject to taxation.
The generation-skipping transfer tax requires taxation on direct gifts that benefit beneficiaries falling into categories that include:
- Beneficiaries you’re not related to and who are more than 37.5 years younger than you.
- Beneficiaries you are related to but are one generation younger than you, including grandchildren.
The IRS imposes this tax if the transfer isn’t subject to a gift or estate tax at each generation level.
Also, who the IRS considers a relative is broad, sometimes allowing for domestic partners who’ve lived in your household for an extended period of time.
Talk with a tax adviser or professional if you have any questions.
Profit from life insurance settlements
If you no longer need or want your life insurance policy, you might choose to sell your policy to someone else for a life insurance settlement. In a life insurance settlement, a buyer takes over your premium payments for the benefit of receiving the policy’s full payout after you die.
The amount of your settlement is decided by you and the buyer, but any profit you make on your settlement may be taxable. The specifics of the tax implications are unclear, so you’ll want to speak with an accountant or financial adviser when considering this option.
Failure to pass a cash value accumulation test
A cash value accumulation test (CVAT) is used to determine the merits of a life insurance policy. In simple terms, the test analyzes the death benefit against the policy’s cash value. If the cash value is too high compared to the death benefit, the IRS generally requires the provider to increase the death benefit in order to comply with the IRS’s tax revenue code.
If your life insurance policy fails the CVAT, the IRS may consider it an investment subject to income tax.
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Life insurance is a complicated coming together of two of life’s certainties, as the saying goes: death and taxes.
With recent tax laws and consistent tweaks to the IRS revenue code, it’s difficult to know how they relate to your future policy payouts.
Talk with a licensed accountant or adviser if you have any tax questions related to your life insurance for advice tailored to your specific financial situation.