Most people know how life insurance works generally, but questions start arising when you get deep into the details. When a beneficiary receives a life insurance payout, do they owe taxes on that payout? Some life insurance policies are quite large, so paying income taxes on the proceeds of a policy could lead to a large tax bill. Thankfully, you usually do not have to worry about paying taxes on life insurance proceeds as long as the beneficiary is a real person. However, there are a few special cases where a tax bill might be due. Here is everything that you need to know about life insurance and taxes including when you might have to pay them and how to avoid them.
Is Life Insurance Taxable?
One of the biggest questions when it comes to life insurance is, “Do I have to file taxes on it?” You can rest easy knowing that life insurance payouts are usually not taxable. If you have a large life insurance policy, then your beneficiaries will probably not have to worry about paying income taxes on the policy proceeds that they receive from the insurance company after your death. The IRS exempts the death benefit that beneficiaries receive from a life insurance policy. In fact, most of the time you never even have to report to the IRS that you received money from a life insurance policy at all.
This can be a big benefit to people receiving life insurance proceeds. Generally, this money is used to help pay for funeral expenses and other financial burdens caused by the death of a loved one. Being required to pay taxes on this money would cause further financial burden. Though the general rule is that no taxes will be due, there are a few special cases when the Internal Revenue Service might come knocking. The next section will detail a few times when you might be required to pay taxes on a policy.
When Life Insurance Payouts May Be Taxable
Though the general rule is that life insurance payouts are not considered taxable income, there are a few exceptions. We will discuss those here. If any of the following situations apply, then you might have a tax bill coming due.
You Earn Interest Income
Interest income almost never goes untaxed, and life insurance payouts are no exception. A life insurance company might pay you interest for a few different reasons. Perhaps the death benefit is not immediately payable, rather it is payable at a later date with accrued interest. Perhaps the benefit is paid as an annuity over time with interest accruing during the period based on the current interest rates. Either way, you will likely owe taxes on the interest that is earned. While the base amount will still pass tax-free, you will have to claim the interest payments and pay taxes on those appropriately.
You Perform A Cash Surrender
Some policies give you the option to surrender them for the cash value of the policy. When you do this, you need to be careful of the tax implications. Upon surrender of the policy, you will probably be required to pay taxes on any cash value that you receive in excess of the premiums that you have paid. In some cases, this might be zero. However, in other situations, this could be more than you paid for the policy. Be sure to talk to your tax professional about how this might impact your tax bill.
Transfer Of A Policy
Instead of purchasing a policy and paying regular life insurance premiums, some people choose to transfer a policy. When this happens, you will usually owe some income tax on the value of the policy that exceeds the transfer fee. This can sometimes get complicated, so you should always consult with a tax professional. However, just know that transferring a life insurance policy means that the new policyholder might owe some taxes.
Life Insurance Proceeds Go To Your Estate
This is one of the biggest mistakes that people make when choosing a beneficiary for their life insurance. The insured person chooses to let the proceeds go into their estate. This means that the proceeds become part of the taxable estate, and then estate taxes and inheritance taxes might become due. The life insurance tax exemption is basically lost, and this could mean that 40% or more of the benefit might get eaten in taxes because estate taxes are quite high.
3 Ways To Avoid Taxes On Payouts
So, you have heard about a few situations that might cause taxes to be paid on the money received from an insurer. So, what can you do to avoid these situations and keep your tax liability at zero? Here are three ways that you can avoid paying taxes and keep the correct answer to the question, “Is life insurance taxed?”
Name The Proper Beneficiary
The easiest thing that you can do to avoid taxes is by naming a proper beneficiary. Make sure that you choose a person as the beneficiary of your life insurance. That person can receive the proceeds as a lump sum and not owe a single penny of taxes even if the payout is quite large. You should also name a contingent beneficiary in case your original beneficiary becomes deceased before you. This ensures that your beneficiary is a real person and thus will qualify for the life insurance tax exemption.
Set Up An Irrevocable Life Insurance Trust
Some people choose to use their life insurance death benefit to fund an irrevocable life insurance trust. In a way, this lets the life insurance proceeds become part of your estate without the negative tax consequences. Of course, technically, the proceeds do not become part of your estate. They are owned by the trust itself. Upon the death of the insured, the proceeds enter the trust, and the trust agreement governs how that money is invested and distributed. This is often used as a form of estate planning. It allows the insured to set the rules for how the trust beneficiaries can access the money, but it avoids the pesky tax consequences of leaving money directly to the estate.
Perform An Ownership Transfer
You may need to transfer ownership of your life insurance policy to avoid the proceeds becoming part of your estate. Whether or not taxes are due can depend on the policy owner at the time of death of the insured. Just be careful when performing the transfer as the IRS has very specific rules regarding ownership transfers. The transfer itself might be subject to gift tax that will be due when it comes time to file your tax return.
Policy Ownership Regulations
One of the biggest regulations when it comes to establishing ownership of a policy is the three year rule. This means that if a policy is transferred within three years of death, it still becomes part of the taxable estate. The original owner must give up all rights to cancel or surrender the policy, change beneficiaries, and really make any changes to the policy at all. In addition, the original owner must not continue to make premium payments. If the original owner continues to do any of these things, the IRS will likely find that an ownership transfer never really occurred, and the tax advantages of the transfer will be lost.
You should talk to your financial advisor about these specific rules, but know that they apply to almost all policy types. Whether you are working with a term life insurance policy, whole life insurance policy, permanent life insurance policy, cash value life insurance, or other type of life insurance coverage, these same transfer rules apply. You will want to follow the rules to the letter to avoid federal estate taxes on your life insurance proceeds, especially since the death benefit on some policies can add quite a large taxable amount to the gross income on your tax return.
The Bottom Line
If set up correctly, a life insurance policy can provide a great financial benefit to the beneficiaries without the need to worry about taxes. Generally, the proceeds from the policy will not be taxable when received by the beneficiary. However, there are a few situations that can trigger tax consequences. Make sure that you properly plan for those situations and avoid them when possible. Follow the tips outlined in this article to reduce your chances of needing to pay taxes on any life insurance proceeds that you might receive.
Frequently Asked Questions (FAQ’s)
Do you have to pay taxes on money received as a beneficiary?
Generally, no, you will not owe any taxes from life insurance that you receive as a beneficiary. One big exception is when you receive interest in addition to the regular proceeds. Interest income is hardly ever tax deductible, so you will be required to pay taxes on the interest. This usually happens when the policy is payable at some future date and allowed to accrue interest in the interim. For example, if you are to receive $100,000 in proceeds with 10% interest, then you may end up receiving $110,000 in total. While no taxes would be due on the base amount of the policy of $100,000, you would owe taxes on the $10,000 worth of interest that you received.
Is life insurance protected from the IRS?
Many people often ask, “Are life insurance proceeds taxable?” Life insurance payouts are generally protected from the IRS. In most cases, you are not even required to report payouts to the IRS on your tax return. So, is life insurance tax deductible? Not really. Just because the proceeds are not taxed does not mean that they are tax deductible. However, make sure that you consult with your tax professional to be sure. There are some instances where taxes might be due on a life insurance policy, especially if you are paid interest on a policy or the policy becomes part of an estate. Proper planning can help avoid these situations and keep your tax bill to a minimum.
What happens to life insurance proceeds if the beneficiary dies?
It depends. If the policy named a contingent beneficiary, then the proceeds will go to the contingent beneficiary. This is why it is extremely important to plan for this situation and name a contingent beneficiary in addition to your primary beneficiary. If there is no contingent beneficiary, then the proceeds will likely go to your estate to be distributed according to your will or the intestate succession laws of your state. Unfortunately, if the proceeds go to your estate, then you might be left with a hefty tax bill. They might no longer pass to a beneficiary tax-free, so this situation might cost you thousands of dollars.
What are the requirements for life insurance to be exempt from taxes?
One of the biggest requirements is to name a real person as the beneficiary. If the proceeds pass to a real person per the terms of the contract, then they are generally exempt from taxes. However, allowing the proceeds to go into your estate can have big tax consequences.
Are proceeds from cashing in a life insurance policy taxable?
If you surrender a policy for the cash value, then that transaction might be taxable. It depends on the surrender value and how much you have paid into the policy in the form of premiums. Your tax advisor can help you determine exactly how much you will owe in this situation.