Life insurance provides a death benefit for the policy’s beneficiaries when the insured person dies. Generally the death benefit is not taxable, but there are some exceptions.
Is Life Insurance Taxable?
Generally the beneficiary of a life insurance policy receives the death benefit proceeds free of tax. However, any interest you might receive on those proceeds would be taxable. This situation might occur if the proceeds are paid into an interest-bearing account at the insurance company. Just like a savings or money market account, the interest earned in this account would be subject to taxes.
Though the proceeds of a life insurance policy are generally tax-free money for the beneficiary receiving the death benefit payment, there are other tax issues such as the estate tax to consider.
Cash Value Life Insurance
Whole life insurance and other types of cash value policies can build up cash value within the policy over time. The cash value accumulates on an ongoing basis as part of the premium payments made on the policy go toward this cash value. The insurance company invests this money on the policyholder’s behalf. The interest and any investment gains on the policy grow tax-free; no taxes are due on these gains within the policy.
Note: should you decide to surrender the policy at some point in the future, the cash value may or may not be taxable. Called the cash surrender value, if the amount of the cash value is greater than the amount of premium payments made on the policy this would result in a taxable event. If the cash value is lower, then there are no taxes due when the policy is surrendered.
Some cash value life insurance policies generate policy dividends, generally on a quarterly or annual basis. These dividends are distributions that can be taken as cash payments, reinvested into the policy’s cash account or used to make premium payments. These dividends are not taxable distributions.
Payouts to the Terminally Ill
Some life insurance policies have riders allowing for benefit payments for terminally and chronically ill policyholders. These payments are not considered to be taxable to the recipient, they are given the same treatment as if they were paid due to the death of the insured.
There is usually an option for the policy beneficiary to receive their payments either as one lump sum or as one or more installment payments. In the case of installment payments, they may receive interest on these payments, this interest on these payments is taxable income. The actual payment of the death benefit remains tax-free.
The federal estate tax applies to estates of more than $11.58 million in 2020. Unless the life insurance proceeds exceed this amount or push the value of the estate higher than this level, then they will not be subject to estate taxes at the federal level. There are wide differences in the existence and level of estate taxes among the various states, so any impact at the state level can vary widely.
Generally if the beneficiary is an individual, the death benefit will not be taxable. However, if the policy beneficiary is your estate, either directly or indirectly, then the death benefit might be taxable if your estate is subject to estate tax issues.
Life Insurance Trusts
One method to ensure that the death benefit proceeds are not included as a part of your estate is the use of an irrevocable life insurance trust (ILIT). This is a form of an irrevocable trust which means that you irrevocably surrender all ownership interests and rights to the policy to the trust. You also cannot serve as the trustee of the trust. The major benefit is that the policy death benefit will no longer be counted as part of your estate.
There are several reasons to consider using an ILIT versus just giving the policy to another individual.
- While you cannot have any direct control over the trust or incidents of ownership in the policy, your attorney, financial adviser, a third-party trustee or even an adult child can serve as the trustee. You can express your wishes to them in terms of changing the trust’s beneficiaries or other related matters.
- This structure allows you to be sure that policy premiums continue to be paid and the policy remains in force. If you make payments to the trust each year to ensure that the premiums are paid, this could be considered a gift that could be subject to gift taxes. As a remedy to this, the trustee can send a “Crummey” notice to the beneficiaries of the trust each time such a transfer is made into the trust notifying them that they can request a share of that money within a specific period of time.
For those who have concerns about having ownership of the policy as part of their estate, they need to conscious of the three-year rule. This rules says that any gifts of a life insurance policy to a trust or another individual or entity made within three years of the policyholder’s death would still be subject to any estate tax issues as part of their estate.
In transferring the policy, the owner must forfeit all incidents of ownership, including:
- Any legal rights to change the policy beneficiaries.
- The right to borrow against the policy’s cash value.
- The right to surrender or cancel the policy.
- Any control over the beneficiary payment options for the death benefit.
In many instances the use of life insurance is a solid way to provide a level of financial protection and security for your loved ones or other beneficiaries. The death benefit is usually paid with no tax ramifications involved.
However, for wealthier individuals with large estates, there can be tax ramifications in terms of the estate tax. While the estate tax limits are high today, this could certainly change over time and become more of an issue for a larger number of life insurance policies in the future.