How to Navigate Taxable Life Insurance Benefits & Minimize Your Tax Burden
Are life insurance benefits taxable? Generally,
life insurance plan beneficiaries receive life insurance death benefits tax-free, but certain scenarios may trigger taxation. This guide explains when a taxable life insurance benefit occurs, including coverage in estates exceeding tax thresholds, interest income on installments and other factors.
Key Takeaways
- Life insurance death benefits are generally non-taxable, but they may become taxable in specific scenarios, such as in a three-party Goodman triangle, or when they’re included in a large, taxable estate.
- Cash value growth within life insurance policies is tax-deferred, but withdrawals exceeding the amount of premiums paid, or policy loans, can become taxable under certain conditions.
- With few exceptions, life insurance premiums aren’t typically tax-deductible. Strategies like using an irrevocable life insurance trust (ILIT) can help you avoid taxes on life insurance proceeds.
When Are Taxes Triggered With Life Insurance Death Benefits?
A life insurance death benefit provides financial compensation for beneficiaries, to support the financial impact of a loved one’s passing. Fortunately, in most cases, these benefits aren’t taxable for the beneficiary. But like many tax-related matters, there are some exceptions to the rule. Consider the following scenarios.
The Three-Party Policy Scenario
When three parties are involved in a life insurance policy, this becomes a “Goodman triangle” scenario. In a Goodman triangle, the parties involved are the insured, the policy holder and a beneficiary who’s not the policy owner. When the insured passes away, the death benefit becomes a taxable gift from the policy holder to the beneficiary.
To avoid the Goodman triangle and the resulting tax implications, the policyholder should also serve as the insured party, so that the life insurance policy scenario is reduced to two individuals.
Interest Income From Deferred Payouts
If the beneficiary chooses to receive life insurance proceeds in installments or delays the payout, rather than receiving the death benefits immediately in a lump sum, that could potentially trigger tax implications on the life insurance death benefits.
This typically happens when interest accrues on the life insurance proceeds. That interest, when it’s applied to future life insurance premium payments or when it’s withdrawn, can be subject to taxes.
Life Insurance Taxes Due to Estate Inclusion
Life insurance proceeds may also be taxable when they’re part of a large estate. If your life insurance policy is included in an estate that exceeds the federal estate tax exemption amount, federal and state estate taxes, as well as income taxes, may apply.
There are ways to avoid this tax obstacle. One method is to transfer ownership of the policy to an insurance trust. It’s important to note that the policyholder needs to survive for 3 years after this transfer to effectively exclude the proceeds from their taxable estate.
How Taxes Affect Cash Value Growth in Life Insurance
In addition to potential taxes on death benefits, there may be tax implications related to cash value growth in life insurance. While term life insurance policies don’t offer cash value growth, permanent life insurance policies can have a cash value component that accumulates on a tax-deferred basis. However, cash value withdrawals and life insurance policy surrenders can trigger taxable events, such as the following scenarios.
Tax Implications of Withdrawing Cash Value
The cash value in a whole life insurance policy, which is a type of cash value life insurance, can serve as a useful financial resource, such as a cash value account. But withdrawing money from this reserve can result in tax implications.
Withdrawals up to the amount of total premiums paid into a life insurance policy are income tax-free. But if you withdraw more than the premiums paid, or you opt to surrender the policy altogether, the excess amount becomes taxable as ordinary income. Also, any gains, such as dividends, that are withdrawn from a policy’s cash value are taxable as ordinary income.
How Loans Against Life Insurance Cash Value Affect Taxes
Did you know that you can borrow against the cash value of your life insurance policy? This may be a helpful financial strategy in certain situations. The good news is, loans against the cash value of life insurance policies aren’t treated as taxable income.
However, tax implications may arise if the life insurance policy ends before the loan is repaid. In these cases, the remaining loan amount can become subject to taxation. Even though loans can be a flexible option, consider the potential tax consequences before you decide to take a loan against your policy’s cash value.
The Impact of Premium Payments on Taxes
Life insurance premiums are generally not taxable and can’t be deducted on tax returns. However, certain scenarios involving employer-paid premiums and state premium taxes can influence your tax liability. Consider the following.
Are Life Insurance Premiums Ever Tax-Deductible?
While you typically can’t deduct life insurance premiums when you’re doing your taxes, there are some exceptions. For example, you may be able to deduct life insurance premiums as a business expense if the payer is not directly or indirectly a beneficiary of the policy. It’s important to consult with a tax professional to understand your unique circumstances.
How to Avoid Taxes on Life Insurance Proceeds
There are ways to minimize or even avoid taxation on life insurance proceeds. One such strategy involves the use of irrevocable life insurance trusts, also known as ILITs. Here’s how.
Benefits of Using a Trust for Life Insurance
An ILIT can be a beneficial financial tool, depending on your unique situation. By owning the life insurance policy and being named as the beneficiary, an ILIT ensures life insurance proceeds aren’t considered part of the policyholder’s taxable estate. This way, death benefits will bypass estate taxes.
There are other benefits of ILITs. They provide additional financial protection, by excluding life insurance proceeds from the reach of creditors, and allow a trustee to responsibly manage and control the trust’s distributions. This strategy can be particularly advantageous for estate planning across multiple generations.
How Do Taxes Affect Life Insurance Settlements?
Life insurance settlements can also be subject to tax implications. Terms depend on the insurance company, so consult with yours to understand the specifics.
For example, while viatical settlements are intended for individuals with life-threatening illnesses and are typically tax-exempt, life settlements may incur taxes based on the excess of the amount received over total premiums paid. To be exempt from federal income tax, viatical settlement transactions require certain documentation, including a physician’s statement about the policyholder’s illness and life expectancy.
How Do Taxes Impact Group Term Life Insurance Policies?
Group life insurance coverage provided by employers is a common employee benefit. But this type of coverage can also have tax implications.
For employer-provided group-term life insurance, the first $50,000 of coverage is excluded from taxation under IRC section 79. However, plans that provide more than $50,000 in coverage may have tax implications for the recipient. If the policy is considered carried by the employer, it may result in a taxable benefit, even if employees pay the full cost charged to them.
Tax-Free vs. Taxable Life Insurance Policy Dividends
Life insurance policies often pay dividends to policyholders, typically seen as a return of premiums and, as such, aren’t subject to taxation. However, interest that accumulates on life insurance dividends may result in taxation if it leads to the policyholder getting more returns, compared to what they paid in premiums. Additionally, the excess dividend amount received over the amount paid in premiums for the policy is considered taxable income.
Need Help Navigating Life Insurance Taxes?
There are many ways to maximize your life insurance death benefit while minimizing your tax burden, including using ILITs and being aware of scenarios that trigger taxation.
Every individual’s tax situation is unique. It’s always important to consult with a tax professional who can guide you through the intricacies of your personal tax situation. In addition to providing financial security for your loved ones, you can make smart life insurance decisions that improve your finances in the present.
If you have questions about life insurance policies,
contact us online or by email at
info@azhealthinsurancebrokers.com, or by phone at 602.617.4107. We can refer you to a life insurance specialist who can help.
Life Insurance Taxes Frequently Asked Questions
Are life insurance death benefits taxable?
In general, life insurance death benefits aren’t taxable to the beneficiary, but there are exceptions to consider, such as interest income from deferred payouts and certain estate inclusion.
Can I borrow against the cash value of my life insurance policy without any tax implications?
Yes, you can borrow against the cash value of your life insurance policy without incurring any tax implications. However, if the policy ends before the loan is repaid, the remaining loan amount can become subject to taxation.
Are life insurance premiums tax-deductible?
No. Generally, life insurance premiums aren’t tax-deductible, unless they’re considered a business expense, and the payer is not a beneficiary of the policy.
What is an irrevocable life insurance trust (ILIT), and how can it help avoid taxes on life insurance proceeds?
An ILIT is a trust that owns a life insurance policy and designates itself as the beneficiary, effectively excluding the life insurance proceeds from the taxable estate and avoiding estate taxes.
Are life insurance dividends taxable?
Life insurance dividends are typically considered a return of premiums and aren’t usually taxable. However, any interest accumulated on dividends may be subject to taxation if it exceeds the premiums paid.
Are life insurance policy loans taxable?
As long as the life insurance policy remains in force, you generally won’t have to pay taxes on the loan you take from a life insurance policy. If you surrender your life insurance policy, or if the policy lapses, and the amount you owe exceeds what you paid in, you could potentially have to pay income tax on any earning from the investment.
If a life insurance policy loan isn’t repaid, what happens to the life insurance death benefit?
If a life insurance policy loan hasn’t been repaid before the insured person passes away, the insurance company will reduce the amount of the death benefit based on what’s still owed.
What are the tax consequences if a life insurance policy is surrendered?
If the surrender value of the life insurance policy is worth more than the premiums you’ve paid, you will have to pay taxes on the excess amount.
Are there income tax implications on life insurance policies with outstanding loans that are given as gifts?
If the loan, including unpaid interest, exceeds the policy’s cost basis, the life insurance policy gift will be viewed as part-sale transaction/part-gift for taxes. The policyholder will be taxed on the amount of the portion of the policy that represented gain.
Is cash value on a whole life policy taxed?
While the cash value of a whole life insurance policy accumulates, it won’t be taxed. This means it’s “tax deferred,” and you won’t have to pay taxes on the value as it grows. However, if you withdraw money from the cash value, you may owe taxes.
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