The death benefits of a life insurance policy are typically tax-free for the beneficiary of the policy, but there are a few circumstances when the payout does generate taxes.
Interest Income
If the death benefit is paid out in installments rather than all at once, it will accrue interest over time. Though the original payout remains tax-free, the beneficiary will owe taxes on the interest. This interest can accumulate quickly depending on the size of the death benefit.
Estate Taxes
One common mistake policyholders make is leaving a death benefit to their estate rather than naming an individual as the beneficiary. This subjects your estate to the probate process and increases your estate’s value, thereby raising your estate’s taxes. If your estate exceeds the federal limit of 12.06 million for 2022, your beneficiaries will be subject to federal estate tax.
Transferring ownership of your policy to another person before you die is an alternative that can help you avoid federal taxation of your estate. By transferring ownership, you relinquish your rights to change the policy.
Another option is to create an Irrevocable Life Insurance Trust (ILIT) with another individual as the trustee. Similar to transferring ownership, you cannot retain any rights. If the policy’s cash value is greater than $16,000, which is the gift tax exemption, you will owe gift tax upon the transfer of ownership.
With both of these options, a trusted family member or friend will be responsible for paying the premiums and can make changes on your behalf, but the life insurance proceeds will no longer be connected to your taxable estate.
Cash Value Withdrawal
Life insurance policies that offer a cash value feature, such as whole life insurance, give you the ability to borrow or withdraw accumulated funds. Withdrawing an amount of money up to the amount of premium you have paid is not taxable, but if you withdraw an amount that is over what you’ve already paid in premiums, or what’s known as the policy basis, you will be required to pay income tax on those funds. Keep in mind that withdrawing too much or failing to repay a loan could also reduce or even deplete your death benefit.
Three Involved Parties
There are three roles when it comes to life insurance: the insured, the policy owner and the beneficiary. In most cases, one person fills dual roles as both the insured and the policy owner. However, if three different people are involved in the transaction, the death benefit will become taxable income for the beneficiary.
A common situation where this occurs is when a spouse owns a life insurance policy on the other spouse and has the children of the family listed as the beneficiaries. Upon the insured spouse’s death, the surviving spouse and owner of the policy would be considered to have made a taxable gift of the death benefit payout to the children of the family. This gift would then be subject to taxation.
Selling or Surrendering Your Policy
You may decide you no longer want your life insurance policy and choose to sell it for cash. If your profits are more than what you have paid in premiums, you will owe income tax on the money you earn from the transaction. When canceling a permanent life insurance policy, the cash value you receive would qualify as taxable income.
Viatical settlements, which involve a terminally ill individual selling their life insurance policy for cash, are the exception to this rule. These payouts are treated as a death benefit payout and are not taxable.
Group Life Insurance
Employer-paid group life insurance premiums are tax-free under $50,000, but you will owe income tax if those life insurance premiums exceed $50,000.
Is My Life Insurance Taxable?
Protecting your life insurance proceeds from taxation ensures that your beneficiaries are fully taken care of upon your death. Americo Senior Life can help you assess your life insurance eligibility and find coverage that fits your needs. Learn more about your life insurance options today!