As Benjamin Franklin once said: “In this world, nothing can be said to be certain, except death and taxes.” We can say this quote still makes the point up to this day. It is only responsible if we consider making plans for both death and taxes.
Having life insurance is a great way to protect your loved ones, but it has many additional financial benefits for you as a policy owner. On the other hand, paying taxes is a necessity.
You should always make sure you’re filing your tax return on time and regularly paying because otherwise, you can be charged with penalties or even become subject to criminal prosecution.
Understanding all of the tax implications involving a life insurance policy is of great importance to both the policy owner and their beneficiaries to make the best decisions about handling the policy’s proceeds.
This article will break down all the scenarios and cases in which taxes come into play and when that is not the case.
Life Insurance Tax: What Are the Rules for Taxation of Life Insurance Policy
Individually, both understanding the basics of life insurance and your taxes is a complicated task. However, it becomes even more confusing to decipher what lies ahead when these two intersect: big tax bills or a tax-free income?
The primary purpose of a life insurance policy is to provide a payout once you pass away, which will financially help your family survive the rough times. Because the policy’s death benefit can be a lifeline for families, state and federal tax laws aim to protect insurance payouts.
If you are named to receive the life insurance death benefit, you may wonder if the proceeds from a life insurance policy are taxable. In most cases, the answer to that question is no. Generally, death benefits are designed to escape taxes.
As a general rule, life insurance proceeds are not considered taxable income. But there is a catch, as these proceeds may end up being taxed as part of the deceased’s estate if the amount being passed to you exceeds state and federal exemptions.
Suppose you are a policy owner and wish to get rid of your policy through a life insurance settlement or surrendering to the insurer, you may be charged with income and capital gains taxes.
In this article, we will cover:
- Types of taxes
- When is life insurance money taxable?
- Are life insurance payouts taxable?
- Are life insurance proceeds taxable?
- Are life insurance premiums taxable?
- Is life insurance tax deductible?
- How can I avoid or minimize tax on life insurance?
- Achieve financial freedom with Infinite Banking
Types of Taxes
Firstly, let’s mention what types of taxes may affect your life insurance proceeds.
Income tax is a type of tax that governments impose on income that you generate as an individual (or as a business) during the tax year. It is then used to pay government obligations and fund public services.
Federal Estate Taxes
Generally, the federal government and some states combine all the deceased’s assets (property, annuities, investments, and life insurance), subtract all they owe (medical bills, loans, credit cards), and tax the final sum. However, most estates are not affected by the federal tax because, as of 2021, only an estate that exceeds $11.58 million per individual gets charged with a 40% federal estate tax rate.
State Estate Taxes
Like the federal estate tax, the estate tax also has an exemption, but the amount varies from state to state but ranges anywhere from $1 million to $7.1 million. Tax rates vary but can be as high as 20%, depending on your state’s tax laws.
An inheritance tax is a bit tricky, as this tax is put on a person who receives an inheritance. The positive thing is that very few people are affected by it. Typically, spouses are exempt from this tax. However, children or domestic partners may be affected by inheritance tax in some states. Make sure to check if you live in one of the states that impose an inheritance tax.
When Is Life Insurance Money Taxable?
The life insurance policy involves up to three different people:
- the person whose life the policy covers, known as the insured
- the person who buys or owns the policy, known as the policy owner
- the person named to receive the death benefit if the insured party dies, known as the life insurance beneficiary
In almost all cases, only two people are involved; the insured individual who bought the policy and their beneficiary (a child or a spouse). However, the IRS might consider the life insurance death benefit a gift if these roles are different.
Let’s suppose you bought the policy to cover your spouse’s life, and your child is named a beneficiary. In this case, the death benefit becomes a gift technically from you (the owner) to your child. You’re considered a donor and can be liable for gift tax in this instance.
If this is the case, you probably don’t need to worry yet, as you might not end up paying the gif tax anyway. Generally, the tax won’t be due until you pass away, and then only if your estate is worth more than $11.7 million, including the gifts of more than $15,000 a year per recipient.
Even though you probably wouldn’t pay the gift tax, you still need to report all gifts on your annual income tax bill.
Are Life Insurance Payouts Taxable?
Most permanent life insurance policies offer some living benefits, and a cash value accumulation is one. You can access the cash value portion of your life insurance policy:
- through a withdrawal
- with a loan
- by surrendering your policy
Your cash value grows tax-deferred, meaning you might expect to pay taxes once you access it. Once you accumulate a significant value, you can withdraw or borrow against your policy. However, the IRS only levies the tax on the amount that exceeds a certain amount, typically the sum of previous premium payments minus any received dividends.
Your insurance company should let you know what amount in a withdrawal is considered “above basis” and subject to tax. As long as you make sure you withdraw less than that, your cash value money is tax-free.
Also, you can always make a tax-free loan against the policy, as long as the loan amount doesn’t exceed the cash value. If your loan amount happens to exceed that, your policy might lapse, and in that case, you would end up paying taxes on loan.
But first, make sure that:
- You understand that withdrawing money from the policy can leave your loved ones with a lower payout, as it may reduce the death benefit.
- Make sure to check if your life insurance policy is a Modified endowment contract (MEC). In that case, different tax rules may come to play, so it’s probably a wise idea to consult a tax professional to guide you.
Are Life Insurance Proceeds Taxable?
As previously mentioned, proceeds from your life insurance policy are usually not taxable. However, there are some exceptions in which you may have to pay taxes.
Payout in Installments
When you receive the life insurance payout in installments instead of a lump sum,
the death benefit can be paid to you in two ways:
- single lump sum
- in installments
Depending on your preferences, you may choose if you want to receive the whole amount at once or in smaller equal amounts over time. For example, you could avoid spending the entire life insurance payout if you receive money in installments. However, as the interest on payouts may still accumulate, the installment payments may become subject to tax, as the interest is taxable.
Beneficiary Is an Estate
Taxes may be involved under the presumption that the policy’s beneficiary is an estate. If the received death benefit lifts the estate’s value over $11,700,000, your beneficiaries will have to file the “United States Estate (and Generation-Skipping Transfer) tax return,” known as a Form 706. Proceeds will usually add to the estate’s value, potentially resulting in higher estate taxes for your heirs.
When You Leave a Cash Value Policy
Owning this type of permanent insurance policy can impact your beneficiaries in several ways:
Exchanging Cash Value for a Death Benefit Increase
In most cases, when the insured person dies, their policy’s cash value reverts to the life insurance company. However, most insurance companies will respect the insured’s request to convert a portion of the cash value to raise the death benefit value.
Cash Value Withdrawals and Personal Loans Against the Policy
If the insured person used their cash value to cover unpaid premiums and other purposes, this could reduce their beneficiaries’ total life insurance payout. Also, if the insured used to borrow against the policy’s cash value, if there was a negative balance on loan at the time of their death, this may result in a reduced life insurance payout.
Are Life Insurance Premiums Taxable?
If you have group term life insurance through your work, your life insurance premiums may be subject to federal income tax.
Suppose your employer-paid supplemental life insurance coverage falls under $50,000, the employee premium payments are tax-free, and you don’t report them as income. That is because the insurance premiums paid by your boss are considered part of the employee’s compensation.
However, if your policy exceeds $50,000 in coverage, it is considered a fringe benefit; you may have to include the premiums for that coverage in your income tax bill. Remember that only the portion of that premium that exceeds $50,000 gets taxed.
Is Life Insurance Tax Deductible?
If you have an individual life insurance policy, life insurance premiums are treated like any other personal expense and aren’t tax-deductible.
On the other hand, some policies provided by an employer or association, such as Group term life insurance policies, have different rules.
As an employer pays these life insurance premiums, the employer may deduct premium payments for up to $50,000 of coverage per employee under the condition that the employer is not the beneficiary.
Ways to Avoid or Minimize Tax on Life Insurance
Suppose you have purchased a life insurance policy as a way to provide financial protection for your loved ones once you pass away. You have read this article, and you want to make sure you’re avoiding these particular situations when life insurance becomes subject to taxes. Do not worry, as there are ways to avoid inheritance taxes and a big tax bill left to your family to pay.
Lower the Taxability of Life Insurance Proceeds
The first thing to do when trying to avoid taxes is not to mistake when naming a beneficiary. Please make sure you choose your family member as your beneficiaries, not your estate, to help them avoid paying the estate tax.
However, if you wish to keep the estate as a life insurance beneficiary, you can still minimize the tax liability with the help of an irrevocable life insurance trust.
Establish the Irrevocable Life Insurance Trust to Protect Your Death Benefit From Taxes
If you have a large estate and want to minimize potential estate taxes, you should name an irrevocable trust as your beneficiary. When you do so, your life insurance payouts will not be considered part of the insured’s estate; thus, they won’t impact the estate’s value. The trust has its unique tax ID number, and the trustees are named to distribute the proceeds to your family members named in the trust. Thus, your loved ones will avoid paying income taxes.
It’s advised that an estate tax professional should set up these trusts. The irrevocable life insurance trusts are ideal for individuals with estates worth over $11.7 million.
Is Life Insurance Taxable? | A Quick Summary
Achieve Financial Freedom With Infinite Banking
What if you want to keep all the benefits of owning a permanent life insurance policy, but all those hefty banking charges and high-interest rates cause you headaches? We might have a perfect solution for you, and it’s Infinite Banking.
Infinite Banking is an excellent step towards reaching your full financial potential and gaining financial independence.
The Infinite Banking Concept
The Infinite Banking concept is a strategic method for utilizing your permanent life insurance to create an endless banking system. It allows you to imitate how a traditional bank operates without depending on a third party.
Instead of borrowing from a bank, you borrow money against yourself and dictate the cash flow while still allowing your cash value insurance to earn dividends, even though you are using that money elsewhere.
You can build wealth while borrowing and repaying the money held in your insurance policy’s cash value account.
Key Steps to Building Your Own Bank
Infinite Banking involves:
- Overfunding (with after-tax funds) a high cash value whole life policy from a life insurance company.
- Accumulation of Cash Value(tax-free) throughout the years you are a policyholder of your Whole Life policy.
- Tax-Free Loans against your Whole Life Insurance policy’s cash value to use for your financial expenses.
The main goal is to follow these three steps and duplicate the process as much as possible to build significant cash value for your own bank. Thus, no matter how unique your financial objectives and unique goals are, the Infinite Banking strategy will help you reach them.
It’s safe to say that life insurance is mostly not taxable. However, we covered the most prevalent instances when you as an insured individual may have to pay tax on life insurance policy proceeds or as a beneficiary receiving the life insurance benefits in which circumstances should you expect to pay income taxes. If you need any additional information, make sure to check with your insurance company provider.
We hope we have interested you with Infinite banking and ways to implement it in your life Insurance policy. To learn more on the topic of how to improve your finances, understanding taxes, wealth-building strategies, and much more, consider signing up for our premium membership! We are looking forward to seeing you at the Wealth Nation community!