Do Beneficiaries Pay Taxes On Life Insurance Policies?
Written By Cameron McDowell
Dec 14, 2021
8 mins read
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Do Beneficiaries Pay Taxes On Life Insurance Policies: A Guide To Taxing Policy Proceeds
A life policy's proceeds are not always tax-free. Without solid estate planning, the estate tax may end up taking a large chunk out of the death benefit, leaving your beneficiary with less funding for their future.
Read on to find out when a policy's proceeds are tax-free and how you can best plan your estate to reduce the taxes that your family will have to pay!
Do Beneficiaries Pay Taxes On Life Insurance Policies?
No, as a general rule your policy's beneficiaries will not have to pay taxes on the proceeds from the policy. The life insurance death benefits received by your beneficiaries aren't included in their gross income as recorded by the Internal Revenue Service (aka IRS). This means that life insurance proceeds typically don't have to be reported for income tax, provided that they were paid out as a lump sum.
Under What Circumstances Do Beneficiaries Have To Pay Taxes?
There are two special instances when a life insurance payout is considered taxable income and is subjected to income tax:
When Interest Is Received Along With The Death Benefit
You may opt to have your life insurance company hold on to the death benefit of your policy for a period of time, then distribute the death benefit to your beneficiary in installments, or at a later date. While the life insurance company is holding on to the death benefit, it will earn interest.
When they start paying installments to your beneficiary, the paid installments can either come from one of two sources:
The principal of the death benefit (including any interest that it earns).
Solely the interest collected from the death benefit.
The principal portion of the death benefit is tax-free, but the interest is considered part of your beneficiary's gross income and will be subjected to income tax.
When The Policy Was Transferred For Cash Or Any Other Valuable Consideration
If a policyholder transferred the life policy to someone for money or other valuable considerations, the policy will be taxed by the IRS. The amount of money excluded from tax is limited to the money (or the value of the consideration) that the recipient paid, plus additional policy premiums that the recipient paid, and other specific amounts. There will be some exceptions to this, so check the IRS rules for more information on how much of the proceeds will be subjected to income tax.
Inheritance And Estate Taxes On Life Insurance Policies
Apart from income taxes, you have to consider if your life insurance proceeds will be subject to estate tax. Under Section 2042 of the Internal Revenue Code, the value of the life insurance proceeds insuring your life will be included in your gross estate if the insurance policy's proceeds are payable to either of the following:
The estate of the insured person, whether directly, or indirectly.
To your named beneficiary or beneficiaries, if you possessed incidents of ownership in the policy at the time of your death.
Some owners choose to make their life insurance policy payable to their estate instead of loved ones or a specific relative. This is a common arrangement for agreements involving financial benefits like annuity payments or IRA accounts and is seen as a fair way to divide the benefits amongst several individuals.
However, the decision to name your estate as the beneficiary will subject your life insurance proceeds to the probate process, along with all the other properties making up your taxable estate. This will delay your heirs' access to the death benefits. This is something you can avoid by simply naming a real and specific person as your beneficiary.
There's another problem that you will face if you make your life insurance proceeds part of your estate: it will increase the value of your entire taxable estate. The more items you leave to your estate, the higher the value it will accumulate. While this potentially increases the amount that your heirs will inherit, this also means that they may have to pay a high federal estate tax.
How Can I Legally Reduce Taxes On My Life Insurance Proceeds?
While it can be difficult to pass on the full amount of your estate tax-free, there are two ways that you can significantly reduce the taxes on your policy's proceeds and give your heirs the best benefits. You can transfer your policy, or establish a trust. Here's a basic description of each method:
Transfer The Ownership Of Your Insurance Policy
When computing estate taxes, the ownership of the policy at the time of the insured person's death will determine whether or not it will be considered as part of their estate and subjected to tax. If you want to keep your life insurance policy's proceeds from being taxed, you might consider transferring ownership of the policy to another person.
Here are some guidelines that you need to keep in mind when transferring ownership of your policy to someone else.
Select the policy's new owner. It can be a competent adult or entity, or the policy beneficiary.
Contact your life insurance company to inform them that you want to assign or transfer ownership of the policy, so you can complete the necessary forms to complete the transfer.
Make sure that you get written confirmation from your life insurance provider that the policy's ownership has been changed.
The new owner or owners of the policy must pay the premiums on the policy.
Ownership transfer is final and irrevocable, so consider the complications of possible divorce or separation when you're planning to name a new owner for your policy.
You are giving up all the rights to change the policy once the transfer has been completed. You can, however, request that changes be made by the new owner if they are a family member, friend, or a child.
Establish A Life Insurance Trust
The second way to keep your insurance money from being part of your taxable estate is to make an irrevocable life insurance trust (ILIT). In this situation, the insurance policy will be held in trust and you will not be considered its owner anymore.
Keep in mind that you are not allowed to be the trustee of this insurance trust, and you cannot keep any rights to revoke the trust if you change your mind. By doing this, the proceeds won't be considered part of your estate.
Several policyholders choose trust ownership instead of transferring to another person. Here are some reasons why:
You want to ensure that all the premiums are paid on time. If you transfer it to another person, they may fail to pay an insurance premium, which will cause the policy to lapse.
If your chosen beneficiaries of the trust's proceeds are your minor children from a previous marriage, establishing an irrevocable trust will let you name any trusted relative of your choice to be the trustee, handling the money for them under the terms of your trust document.
You want to retain legal control of the insurance policy.
Incidents Of Ownership Can Negate Tax Advantages
The IRS will look at the conditions and circumstances surrounding the transfer before deciding if it's part of the original owner's estate. Simply put, if you caused an ownership transfer of your policy, but you still exercise all of an owner's rights over it, the IRS will consider you the owner anyway for purposes of deciding tax liability. This makes your estate liable for taxes, even if in name, there was already a transfer.
To prevent this from happening, the original owner of the life insurance policy must do the following:
Forfeit the legal right to change the policy's beneficiaries or select beneficiary payment options.
Forfeit the legal right to surrender or cancel the policy.
Forfeit the legal right to borrow against the life policy.
Not pay the premiums which allow the insurance policy to remain in force.
What Is Gift Tax?
Transferring an insurance policy to a beneficiary may help you reduce estate tax, but it potentially makes the policy subject to gift tax. This is the federal tax imposed on a person giving something of value to another person.
Typically, the giver of the gift is the one who pays these taxes. However, there can be special conditions where the receiving person can pay the federal gift tax instead – or won't have to pay any taxes at all. Here are two of the common ways that US tax laws make this money tax-free:
Giving A Gift Within The Exclusion Limit
There is an annual gift tax exclusion: you can gift up to $15,000 per person without that gift being subjected to taxes. If your policy's cash value amount is $15,000 or less at the time it was gifted, then it won't be subjected to tax. But if your policy's current cash value exceeds that $15,000 per person threshold, gift taxes will be assessed and deemed due at the time of the policy owner's death.
Giving A Gift To Your Spouse
If your spouse is a US citizen, the U.S. Federal Estate and Gift Tax Law have a special, unlimited marital deduction. This allows individuals to transfer unrestricted amounts of money or other assets to their spouses any time, tax-free. The term "any time" applies to the death of the transferor, so your policy's cash value can be given to your spouse with this tax exclusion.
If they are not a US citizen, don't fret. As long as the cash value of your life insurance policy doesn't exceed the exemption amount of $157,000 (as of 2020), it will not be subjected to this tax.
What Is The Three-Year Rule For Life Insurance Policy Ownership?
This rule states that if you gift a life insurance policy within three years of your death, the policy's cash value will still be subjected to federal estate taxes. This tax will also apply in cases where there is ownership transfer of the policy, or if an irrevocable life insurance trust was established.
For estate tax purposes, this means that if you die within three years of transferring the insurance policy's ownership, the full amount of the life insurance proceeds will be considered part of your estate, as if you were still the policy owner at the time of your death.
Estate planning needs to be very thorough to make sure you don't accidentally overlook a rule, so your best bet is to consult a financial adviser who can cover all the bases.
Get in touch with Wesley Insurance, LLC to find out the best way to reduce the income tax on your policy's cash value. We'll answer all your questions about taxes on life insurance and help you choose the best method for maximizing your policy's cash value!