Situations which renders proceeds of life insurance taxable
Proceeds of life insurance are not usually taxable as income, but they can be taxed as part of your estate if the amount left to your heirs exceeds federal and state exemptions. If you decide to get rid of your policy through a life insurance settlement or by surrendering it to your insurer, you may be subject to income and capital gains taxes.
There may be instances where the beneficiary is taxed on some or all of the proceeds of a policy. If the policyholder chooses to have the benefit held by the life insurance company rather than paid out immediately upon death, the beneficiary may be required to pay taxes on the interest earned during that time.
When a death benefit is paid to an estate, the person or people who inherit the estate may be required to pay estate taxes.
If different people fill each of the policy’s three roles, the death benefit may be subject to gift tax:
- The insured is the individual whose life is protected by the policy.
- The policy owner is the individual who purchases and/or owns the policy.
- If the insured party dies, the beneficiary receives the death benefit.
Read Also: 5 Misconceptions about Life Insurance
Proceeds of life insurance taxable
When the estate’s value exceeds certain federal and/or state thresholds
If a decedent’s estate exceeds the federal or state estate threshold, taxes must be paid.
When a “skip person” is designated as the beneficiary
“Skip person” is a beneficiary who is two or more generations younger than the deceased is referred to as a skip person. A grandchild or great-grandchild, for example, is a skip person.
Life insurance proceeds are not considered part of the estate and are not taxed when a spouse or child is named as a beneficiary. If the beneficiary is a skip person, the death benefit value is considered part of the estate.
Taxes will be levied if the total estate value exceeds the federal and/or state estate thresholds.
When there are 3 people involved
A life insurance policy typically involves only two parties: the policyholder (who is typically the insured party) and the primary beneficiary. In that case, no tax is due.
Assume a parent buys a life insurance policy for their adult child and names the child’s spouse as the beneficiary. While it’s a nice gesture, the spouse will have to pay taxes on the death benefit because three people were involved.
In this instance, the answer to the question of whether insurance proceeds are taxable is “yes.”
When a policy is sold
There are many people who want to either broker the purchase or buy an existing whole-life policy. It will be taxed if it is sold for more than it cost.
When there is a profit
It’s not uncommon for someone to surrender their whole life policy and collect the cash value, then use that money to buy a term life insurance policy. Do you have to pay taxes on surrendered life insurance?
Yes, if the amount received exceeds the premiums and fees paid into the policy.
Proceeds of life insurance are NOT taxable
When it does not exceed the estate tax thresholds
The federal government does not tax life insurance unless it exceeds the federal estate tax limit. The limit is set at $12.06 million as of 2022. Moreover, only 13 states currently impose a death tax, though the amount is too high to affect most people.
Most beneficiaries will never have to pay a life insurance tax if the decedent’s estate is worth less than $12.06 million (or the state limit).
When an insurance company holds onto the cash value
Whole life insurance is a type of cash value life insurance policy. That is, a policy can accumulate cash value, which can be used to pay premiums or as collateral for a life insurance loan.
When the policyholder dies, the insurance company pays the death benefit to the beneficiaries but keeps any cash value. There are no taxes to pay because beneficiaries rarely receive the cash value.
When a policyholder withdraws a portion of money
The cash value mentioned earlier is one reason why some people prefer whole life policies. It is not taxable if the policyholder withdraws a portion of the cash value while they are still alive.
If they do not repay the money before they die, the balance will be deducted from their death benefit, leaving their beneficiaries with less.
When a whole life insurance policy is surrendered
Assume a policyholder decides that they have enough money in the bank to provide for their beneficiaries after death and cancels (or surrenders) their policy. Most insurance companies will refund any money that has accumulated in the account, less any surrender fees (which can be costly).
The lump sum of cash is not taxable as long as it is less than the total amount paid into the account by the policyholder.
When annual dividends exceed annual premium payments.
Some whole life policies pay out cash dividends on an annual basis. The dividend is not taxable unless it exceeds the amount paid in premiums by the policyholder that year.
When death benefits are paid out early
When a policyholder is diagnosed with a terminal illness and given a life expectancy of less than two years, they can choose to receive some or all of their death benefit before dying.
It makes sense for someone who needs money to pay for medical treatment. In essence, they become their own beneficiary and are exempt from paying taxes on the proceeds.
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