Thinking about selling your life insurance policy? As you consider your options, you’ll likely wonder about the implications of taxes on life insurance payout. Thankfully, in many situations, beneficiaries can breathe a sigh of relief – the death benefit from a life insurance policy is generally not subject to income tax. But as with most things tax-related, there are exceptions, and it’s essential to understand the nuances. This article will cover when beneficiaries pay taxes on life insurance proceeds. We’re here to break it down for you so you can make informed decisions about your future.
When Taxes on Life Insurance Payout May Apply
While you may have heard that life insurance proceeds are always tax-free, there are a few circumstances where taxes might come into play. Let’s explore these less common scenarios where beneficiaries may need to be aware of potential tax obligations.
Estate Taxes: For Larger Estates
For most folks, estate taxes won’t be a concern. However, if you have a sizable estate, things could get a bit more complex.
This tax only applies to estates that exceed a certain value, set by the federal government. The federal estate tax threshold currently sits at $13.61 million as of 2024. If the total value of a deceased person’s estate, including life insurance proceeds, surpasses this, the portion exceeding that limit will be subject to federal estate tax. About a dozen states also impose their own state estate taxes.
Their thresholds can vary, so check your state’s regulations. For those who have a high net worth, including the proceeds from their life insurance in their estate plan requires careful planning and could require paying taxes.
Taxable Interest: Choosing Installment Payouts
Life insurance beneficiaries often receive the death benefit as a single lump sum payment. But some opt for a series of installments.
While the death benefit itself remains generally tax-free, interest earned on those installments becomes taxable income. This means the beneficiary will need to include that interest income on their tax return.
Think of it this way: When you receive installment payments, it’s similar to putting the money in a savings account where it accumulates interest. It’s that interest that the IRS is interested in.
Transferring or Surrendering Your Policy
Did you know you can transfer ownership of your life insurance policy or cash it out while you’re alive? In some situations, this can lead to taxes.
If you surrender your policy to the insurance company, you’ll receive a “surrender value”. Any amount received beyond what you’ve paid into the policy (the “cost basis”) is taxable as ordinary income.
Similar rules apply if you transfer your policy to a third party for a valuable consideration, known as a “life settlement”.
Income Taxes on Employer-Paid Group Life Insurance
Some employers generously provide their employees with group life insurance as a benefit. Usually, this death benefit is tax-free for beneficiaries.
However, there’s a limit. If the employer-paid group life coverage is over $50,000, the Internal Revenue Service (IRS) considers premiums paid on the coverage above that limit taxable income to the employee.
Although the death benefit itself remains tax-free for the beneficiary, the employee may face income tax implications for the excess coverage during their working years.
A Real-Life Example: Navigating Taxes on Life Insurance Payout
Let’s imagine a situation involving Sarah, who owns a term life insurance policy. Her daughter, Jessica, is named as the beneficiary.
When Sarah passes away, Jessica receives a lump sum death benefit of $500,000. Because this is a standard death benefit payout from a typical life insurance policy, Jessica won’t owe income taxes on that money.
But, what if Jessica chose to receive the payout in installments over time instead of a lump sum? Any interest generated by those installment payments would be considered taxable income and Jessica would have to report it on her tax return.
Now, imagine that Sarah had a very large estate, exceeding $13.61 million, and had made Jessica the beneficiary of a very large policy with a death benefit of $5 million.
Her estate might need to pay estate tax on the combined value exceeding the federal threshold, as the federal exemption only allows $13.61 million.
Minimizing Taxes: A Thought
Want to limit the possibility of paying taxes on your life insurance payout? One idea is to avoid using your life insurance policy to directly pay estate taxes.
Instead, think about setting up an irrevocable life insurance trust (ILIT). If structured correctly, this can help protect the death benefit from estate taxes.
Talk with a qualified financial advisor about your specific situation and needs.
Conclusion
Understanding the rules governing taxes on life insurance payout helps to dispel the misconception that these payouts are always free from taxation. When a beneficiary receives the proceeds as a lump sum from an individually owned life insurance policy, they typically won’t owe federal income taxes.
However, substantial proceeds can push the total estate value past the federal threshold for estate tax, leading to tax obligations. Installment payments generate taxable interest which could also lead to a tax liability. Employer-paid group life exceeding a certain limit may have tax implications for employees, too.
If you’re looking for help with getting life insurance leads be sure to seek the advice of qualified professionals who understand this subject thoroughly.