When it comes to life insurance, there are a lot of misconceptions about whether or not the proceeds are taxable. The answer is…it depends. In this blog post, we will discuss when life insurance payouts are and are not taxable. We will also provide some tips on how to minimize the taxes you have to pay on your life insurance payout.
- Are Life Insurance Proceeds Taxable?
- Do Beneficiaries Pay Taxes on Life Insurance Policies?
- Income Earned From Life Insurance Interest
- Inheritance Taxes From An Estate
- Avoiding Taxation Using an Ownership Transfer
- Avoiding Taxation Using Life Insurance Trusts
- Life Insurance Regulations
- Are Life Insurance Premiums Tax-Deductible?
- Are Life Insurance Dividends Taxable?
- Provide Tax-Free Proceeds To Your Beneficiary
- Need Help Getting Life Insurance Coverage?
- Frequently Asked Questions
Are Life Insurance Proceeds Taxable?
Can life insurance be taxed? Generally, the money you get from life insurance when someone dies is not part of your gross income, and you don’t have to report it.
Is life insurance part of an estate? If the estate is named the beneficiary or there are no living designated beneficiaries, yes. However, any money from the cash value (if any) you receive is taxable. So report it as interest and pay the taxes.
Do Beneficiaries Pay Taxes on Life Insurance Policies?
If you are a beneficiary of a life insurance policy, do you have to pay taxes on the money that has been received? Unfortunately, the answer is not always straightforward. In this article, we will discuss what happens when beneficiaries receive an insurance payout.
The Lump Sum Payout
In most circumstances, the proceeds from a life insurance policy are not taxed as long as the proceeds are taken immediately.
If you name a person as the beneficiary of the life insurance policy, the proceeds will not be taxed. So with that said, if you are a beneficiary inheriting a death benefit from a life insurance policy, the proceeds are most likely tax-free.
Interest Earned Over Time
If the beneficiaries receive the life insurance proceeds after a period of time, the interest earned over time is taxable, not the original benefit.
Estate Taxes and Inheritance Taxes
When you name the estate as your beneficiary, you surrender the contract’s benefit of naming a real person and subject the financial instrument to probate, which is a legal procedure for distributing assets after death. Giving belongings to your estate also raises the value of your estate, possibly resulting in very high inheritance taxes.
IRS Code Section 2042 states that if the proceeds are payable to your estate, either directly or indirectly, or to named beneficiaries, if you had any “incidents of ownership” in the policy at the time of death, the value of life insurance benefits insuring your life is included in your gross estate.
Can you get life insurance on anyone? Yes, you can. If you want your life insurance death benefit to avoid taxes, you need to transfer ownership of the policy to another person or entity.
Here are a few things to keep in mind while conducting an ownership transfer:
- Select someone qualified to be the new owner.
- The premiums on the insurance must be paid by the new owners.
- You will forego the opportunity to make any future changes to this policy.
- When choosing the new owner of the life insurance policy, keep divorce situations in mind.
- As proof of the ownership change, get a written statement from your insurance company.
Avoid Taxation by Using Life Insurance Trusts
To get rid of life insurance money from your taxable estate, you can establish an irreversible life insurance trust (ILIT). You cannot be the trustee of the trust and retain any rights to terminate it. The policy is placed in the trust, and you will no longer be considered the owner. As a result, the funds are not considered part of your estate.
Income Earned From Life Insurance Interest
Taxes are very important. When someone earns interest, they have to pay taxes on it. Life insurance is no exception.
- Life Insurance Proceeds At Death = Tax-Free
- Interest From Cash Value While Alive = Taxable
Inheritance Taxes From An Estate
Are life insurance proceeds included in gross estate? It would be best if you did not name the estate as your beneficiary. When you do, you can’t leave items to a person like a friend or family member. You also might have to go through probate. When you do this, it increases the value of your estate, and it could mean higher taxes for your heirs.
Section 2042 of the Internal Revenue Code says that if you have life insurance and it pays money to your estate, it is included in your taxable gross estate.
Avoiding Taxation Using an Ownership Transfer
The new federal tax law has a higher exemption amount. The exemption is $11.4 million in 2019 and will be $11.5 million for 2020 and 2021. It also has a lower maximum estate tax rate of 40%.
If you want your life insurance to avoid taxes, you need to transfer it to another person or entity before you die.
Ownership Transfer Guidelines
- Find someone who can be the new owner. Then call your insurance company to get the right forms to designate the new owner.
- The new owners have to pay for the insurance. But they can gift up to $15,000 per person in 2020. That means the person who gets this money could use it to pay for their premiums.
- This policy means that you will not be able to make changes to it later. But if you name another person the new owner, they can change the policy at your request.
- Beware of divorce situations when planning to name the new owner. The original owners can’t change their minds after they do it.
- Obtain written confirmation from your insurance company.
Avoiding Taxation Using Life Insurance Trusts
Are life insurance proceeds taxable to a trust? Another strategy for keeping life insurance proceeds out of your taxable estate is to set up an irrevocable life insurance trust (ILIT). This means you can’t be the trustee and forfeit all rights. Utilizing this strategy, the policy will no longer show as part of your estate.
Trust Ownership vs. Individual Ownership
An ILIT is a trust for insurance policies. You can put the insurance policy in the trust, which means that someone else will take care of paying premiums. But you still remain in some control and do not have to worry about the new individual owner not being able to pay the premiums.
Life Insurance Regulations
The IRS provides rules to determine who owns life insurance policies if an insured person dies. According to a regulation known as the three-year rule, gifts of life insurance made within three years of death are still liable for the federal estate tax. This applies both to transfers of ownership and establishing ILITs.
The IRS looks at any incidents of ownership by the person who transfers the policy. When you transfer a policy, you lose the right to change your beneficiaries, borrow against it, surrender it or cancel it.
Another requirement is you must not pay any premiums to maintain the account in force.
When considering whether to make a policy transfer as a gift, it’s important to look at the tax implications. If the value of the transferred assets is more than $15,000 and ends up being taxable, taxes will be assessed and due at the time of death.
Are Life Insurance Premiums Tax-Deductible?
Is life insurance tax deductible for a Limited Liability Company (LLC)? In the traditional sense, life insurance premiums are not tax-deductible.
Can Life Insurance Be A Business Expense?
Life insurance premiums can be tax-deductible as a business expense if the insured is an employee or corporate officer of the company and the company is not the beneficiary of the life insurance policy.
Employers offering group term life coverage to employees can deduct the first $50,000 of benefits that they pay for each employee. This does not count as income for the employee.
Are Life Insurance Dividends Taxable?
If you have more money from your dividends than the total amount of premium payments paid, this is taxable income. In addition, if you leave your money with the insurance company, that interest earned will be also be considered taxable.
Provide Tax-Free Proceeds To Your Beneficiary
Need Help Getting Life Insurance Coverage?
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Frequently Asked Questions
Are life insurance payouts taxed?
Generally, when you get life insurance money because someone died, the government doesn’t tax the money. But if you earn interest from the life insurance company, that is taxed and you should report it as income.