Is Life Insurance Taxable?

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    Is Life Insurance Taxable? A Guide To Life Insurance Taxability

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    Whether you’re your family's sole breadwinner or your parents’ only child, life insurance is a great way to make sure your loved ones will be financially secure when you pass on. But as the saying goes, “the only certainties in life are death and taxes.” And when you do pass away, it’s only natural to want to know if those you leave behind will have to deal with taxes on the payout.

    The short answer to the question “is life insurance taxable” is, technically, no. Typically, your beneficiary will receive a non-taxed death benefit which they can use any way they prefer. But there are certain factors that affect life insurance taxability, such as when you have a cash value policy or group life insurance. 

    It’s always better to read up and prepare your beneficiaries for life’s inevitabilities. So here’s everything you need to know about the taxability of life insurance.

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    The Basics Of Life Insurance

    Before we get started, let’s review the basics. Understanding these components is the key to understanding when and how a life insurance policy becomes taxable, and when and how it can be tax free.

    In a nutshell, life insurance is a contract between an insurance company and a policyholder which states that the former pays the latter's beneficiaries a "death benefit" upon their demise. The insurance is paid for by the policyholder either with a one-time upfront premium or a series of premiums to be paid over time (typically on a monthly on annual basis).

    There are two main types of life insurance: term life insurance, which expires after an agreed upon time, and whole life insurance, which doesn't expire and usually includes a cash value. This is an important component that can dictate whether life insurance is taxable or not. In fact, the cash value makes a life insurance policy similar to an IRA or 401(k) – it's tax-deferred money that can grow inside the life insurance policy. Although it can't be taxed while it remains with your insurance company, the cash becomes taxable once withdrawn.

    We'll go more in depth on the two types later. First, let's discuss the death benefit.

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    When Is The Death Benefit Taxable?

    The death benefit is the money your beneficiaries receive when you die. Typically, life insurance proceeds are nontaxable and are given to beneficiaries as a lump-sum payment, meaning relatives receive the money in full rather than in installments. There are no limitations to how a beneficiary can make use of their life insurance proceeds. Usually, the insurance proceeds are used by the family to settle funeral arrangements, hospital bills, and cover immediate expenses that their deceased relative left behind.

    As mentioned, a beneficiary wouldn't normally have to pay taxes for their insurance proceeds, but there are a few exceptions to this rule:

    Estate Tax

    Your estate is the sum of your assets, from money to properties. When you die, your estate is passed to a personal representative, who then distributes the assets to your remaining heirs. If you have a will, your estate will be distributed according to your wishes. However, if you die without a will (or if the will is considered invalid), your estate will be distributed based on the rules of intestate succession, or the list of heirs who have the first rights to parts of your estate.

    If you make your life insurance proceeds payable to your estate – meaning that you own your insurance policy when you die – you subsequently increase the value of your estate. While this might sound good on paper, the heirs to your estate may think otherwise. This is because the more valuable your estate is, the higher the chances are that the assets will be subject to estate taxes. 

    According to the IRS, estate tax is "a tax on your right to transfer property at your death". The federal estate tax exemption limit is at $11.58 million, meaning that if your estate exceeds this amount, your heirs are required to file a tax return.

    Inheritance Tax

    Depending on where the policyholder lives, their heirs may have to deal with inheritance tax on top of estate tax. Inheritance tax is a tax imposed on those inheriting the deceased's assets.

    The bad news is that inheritance tax is calculated as a percentage of the total value of what you'll inherit, and sometimes this can range between 15 and 20 percent. The good news is that inheritance tax is not imposed nationwide. In fact, only six states have inheritance tax: New Jersey, Pennsylvania, Nebraska, Kentucky, Maryland, and Iowa. If you want to avoid burdening your heirs with inheritance tax in the future, you may want to consider moving out of state.

    Gift Tax

    One of the ways policyholders can avoid estate taxes is by transferring their life insurance policy to a beneficiary, such as a spouse or a child. However, when you do this the IRS considers the life insurance policy as a gift, and thus imposes a "gift tax". In 2020, you can give up to $15,000 in a year (per recipient) before you're taxed. The lifetime exclusion for taxation is $11.58 million.

    It's important to note that gifts given to spouses are not taxed, and neither are charitable donations given to charities and nonprofits.

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    Term vs Whole: Which Type Of Insurance Is Taxable?

    As mentioned, the two main types of life insurance are term and whole insurance. The former is a type of insurance policy that lasts for a set amount of time, called a term. These can last anywhere between 10 and 30 years. When you die, the death benefit goes straight to your beneficiaries tax-free. If you outlive the term, you can either purchase a new term policy, convert your current policy into a whole policy, or request for a refund on your premiums. Term insurance policies are simple, straightforward, and most importantly, tax-free.

    On the other hand, whole life insurance gets a bit more complicated. On top of the agreed upon death benefit, there is a cash value, which is a tax-deferred savings account that accrues interest over time. This is the biggest advantage of whole insurance policies. On top of this, policyholders can make withdrawals from their cash value whenever they want, just like in a regular savings account.

    While the cash value is tax-deferred, meaning you'll only get taxed once you start withdrawing, it's likely that you'll only have to pay for tax if you withdraw past the "policy basis" or the total cost of premiums you've paid over time. However, there are some instances in which the cash value becomes taxable, this includes:

    When You Agree To A Life Settlement

    This is another way of saying you want to sell your insurance policy. When you do this, you transfer your life insurance policy to a third-party investor in exchange for cash.

    Most often, people sell their life insurance policies because they can't keep up with the premium payments or they no longer need the policy because they've lost their beneficiary. But, it should be noted that you have to meet certain criteria to be eligible for life settlement, such as age, policy type, and policy size. Normally, people who go for life settlement are past the age of 65 or have a serious health issue.

    As for the taxation, you're required to pay up for the following:

    • Income tax on proceeds received beyond the policy basis
    • Capital gains tax on proceeds exceeding the insurance policy's cash value

    If you're unable to continue paying for your premiums, another option you can take is to simply surrender your policy.

    When You Borrow Against The Cash Value Of Your Policy

    If you ever find yourself in a tight spot financially, you can request for a loan from your insurance company. A loan against an insurance policy is not usually taxed as long as you don't exceed the sum of premiums you've made to the policy. However, once the policy is surrendered or simply lapses, you or your beneficiaries must repay the loan with the remaining cash value (which, as mentioned, is taxed).

    While taking out a loan from your insurance policy can be considered just another form of a personal loan, some financial experts consider this method a "ticking tax bomb" that heirs will likely have to deal with when the time comes.

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    When Else Is Life Insurance Taxable?

    Aside from the aforementioned circumstances, there are a couple more instances in which you may have to pay taxes for your life insurance policy. Let's take a look:

    When You Receive An Annuity

    Earlier, we mentioned that life insurance proceeds are normally given as a lump-sum payment. However, if a beneficiary prefers it, they can receive their proceeds in increments. This is known as an annuity. Some people prefer annuities because they resemble a steady stream of income and can be beneficial to retirees who no longer receive monthly payslips. And for folks who are not comfortable managing large sums of money, receiving smaller amounts on a regular basis can feel less risky.

    Most life insurance policies dictate that annuities can be granted on the condition that the benefit will accrue interest over time. While you still don't have to pay taxes for your death benefit, you will likely be taxed on the interest you accrue.

    When You Have Group Insurance

    Group-term life insurance is a type of insurance that is commonly offered by employers as a fringe benefit. To be eligible for a group-term insurance policy, you must meet certain criteria set by your employer. Most often, employers require policyholders to be regular employees. Coverage usually amounts to the employee's annual salary, making the insurance akin to a secondary income.

    Up to a certain point, a group-term life insurance policy is not considered taxable life insurance. Specifically, employees are not required to pay income tax on the first $50,000 of their coverage. However, if the policy exceeds $50,000, the employee must pay income tax.

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    Conclusion

    Death and taxes are the only two certainties in life! As we prepare for the inevitability of death by making sure our loved ones will be financially secure in our absence, we must also prepare for the possibility of taxes. After all, the point of life insurance is to give our beneficiary a stable life when we pass, and allowing taxes to derail this defeats the purpose altogether.

    For the most part, life insurance is not usually taxed, but it can be taxable under certain circumstances. Knowing these circumstances will help you and your family prepare for the inevitabilities. At Wesley LLC, we can walk you through the ins and outs of life insurance and help make sure that your heirs will be well taken care of in the future.

    Written By Cameron McDowell
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