By Joe Dyton, WCI Contributor

Purchasing a life insurance policy is one of the most financially sound decisions you can make if you have loved ones who depend on your income. Life insurance helps ensure that your family has at least some financial protection and relief in the event of your death. The policy could help your family pay off any outstanding debts you might have, keep up with housing payments and day-to-day expenses, fund your children’s college educations, and more. But all of that incoming life insurance money could have tax implications for those who receive it.

Buying life insurance and paying your premiums is just part of the equation when it comes to making sure your family is provided for in the event of your death. You also want to ensure that your beneficiaries receive as much of the payout as possible and not lose a chunk of it to taxes.

Here’s a closer look into how taxes work when it comes to life insurance benefits.

 

Are Life Insurance Proceeds Taxable?

Typically, life insurance proceeds paid out to beneficiaries in the event of the policyholder’s death don’t count as gross income. That means the proceeds don’t have to be reported, according to the Internal Revenue Service (IRS). So, if your life insurance policy face amount was $500,000, your beneficiaries would receive $500,000 in death benefit proceeds, $0 of it would count as gross income, and they would owe nothing in taxes on that money.

There are exceptions, however. For example, any interest gained on the policy is taxable and should be reported to the IRS as such. Additionally, the IRS notes on its website:

“If the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts. There are some exceptions to this rule. Generally, you report the taxable amount based on the type of income document you receive, such as a Form 1099-INT or Form 1099-R.”

 

Why Would Interest Be Paid on Life Insurance?

How your life insurance proceeds are paid to your beneficiaries will also determine if they will be taxed. If the proceeds are paid in one lump sum, they won’t be taxed. On the other hand, life insurance proceeds paid out in installments with interest are subject to tax. The portion of the installment that constitutes interest instead of principal counts as taxable income every year.

The idea that installment payments are taxed while one-time payments aren’t might lead some to ask: why would anyone request life insurance proceeds be paid out in installments? The installment option may work better for parents if their beneficiary is a young child or someone who’s solely dependent on their income. While the beneficiary would have to pay income tax on the interest, receiving proceeds in installments might help them manage the funds more easily.

Note that the principal would still be paid out tax-free, so most of the payment would still be tax-free.

 

What About Surrendering a Whole Life Policy?

If you surrender a whole life policy, you will pay ordinary income taxes on any gains on the policy. Gains are the amount you received minus the total of premiums paid. Unfortunately, if you surrender that policy for a loss, you cannot deduct that loss on your taxes. You can do a 1035 exchange into a low-cost variable annuity, allow the value to grow back to the basis amount (total of premiums paid), and then surrender it. At least this would provide you with some tax-free future gains, allowing you to make a bit of lemonade out of the lemons of your loss.

 

How Do Estate and Inheritance Taxes Work?

Your life insurance tax situation could work differently if your policy’s value is folded into the rest of your estate. Your estate value does not matter as much if you named your spouse as your beneficiary. The proceeds aren’t taxed in that case—your spouse will receive the full payout, along with whatever else in your estate that you left them. Additionally, your spouse will likely be exempt from estate taxes.

The situation is a bit trickier if you name someone other than your spouse as a life insurance beneficiary, like your children or parents. In one of these instances, the payout is added to your estate’s value. If the add-on doesn’t push your estate’s value over federal exemptions ($12.06 million for a single person in 2022 and $24.12 million for a married couple) and state exemptions, there’s nothing to worry about in terms of inheritance or estate taxes. If your estate value exceeds those exemptions, however, every dollar over the threshold will be subject to inheritance and estate taxes.

You should also think twice before naming your estate as your life insurance beneficiary. Doing so not only forfeits some of the contractual benefits that come with naming an actual person as the beneficiary, but it also increases your estate’s value. The higher your estate’s value, the more your heirs will have to pay in estate taxes.

 

How to Transfer Life Insurance Ownership to Avoid Taxation

Your life insurance proceeds can be excluded from your federal taxable estate if someone else owns the policy at the time of your death. You can set up this scenario by transferring ownership of your policy to another individual or creating an irrevocable living trust and transferring policy ownership to it.

If you opt to transfer ownership to someone else, you forfeit any power you had over the policy forever. You can’t cancel the transfer or change the beneficiary, even if you gave ownership to your spouse and you get divorced.

You should also transfer life insurance policy ownership as quickly as possible because the IRS requires that the process happens more than three years before the policyholder’s death. Otherwise, the transfer is forfeited for federal real estate tax purposes and potentially state estate taxes, as well. If that happens, 100% of your life insurance proceeds remain with your estate, just as if you owned the policy all along.

paying taxes life insurance

For example, if you transferred ownership of your $500,000 life insurance policy to your child and you died two years later, the proceeds would be disallowed in terms of avoiding taxation. The $500,000 would be included in your taxable estate.

Remember, the tax issue is moot if you leave your insurance proceeds to your spouse. They won’t be subject to estate taxes in the event of your death. The estate tax comes into play when you name anyone besides your spouse (children, friends, family members, etc.) as the beneficiary.

Here are a few steps you should take when transferring your life insurance policy ownership to avoid taxation:

  • Notify your insurance company once you’ve selected a new policy owner.
  • Remember that the new owner or owners have to pay policy premiums. You may gift the new beneficiary or beneficiaries up to $15,000 per person in 2021 and $16,000 in 2022 to help them pay the premium.
  • Get written confirmation from your insurer to confirm the ownership transfer is complete.

Your other option to avoid life insurance proceeds taxation is to create an irrevocable life insurance trust. Just as when you transfer policy ownership to an individual, you’d lose control over the policy in this scenario, too. You also cannot be the trustee. On the plus side, your life insurance proceeds won’t be included in the rest of your estate.

Additionally, an irrevocable life insurance trust offers peace of mind. You don’t have to worry about whether a beneficiary will keep up with the policy premiums. A trust will make payments on time without fail. The trust also is a good option if the policy beneficiaries are young children. You can name someone you trust as the trustee to handle the funds for the children based on the trust’s terms.

 

Conclusion

There’s a chance your life insurance policy proceeds will be taxed depending on who you name as the beneficiary and how the money is paid out (lump sum or installments). This should not discourage you from purchasing a life insurance policy, however. In the event of your passing, your loved ones will be in much better financial shape with a taxed life insurance payout than with nothing at all. In the meantime, take a look at the steps you can take to help them avoid as much taxation as possible.

 

Have more questions about life insurance and what kind of policies would be the best for you? Hire a WCI-vetted professional to help you sort it out.

 

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