Are Life Insurance Payouts Taxable?

Introduction:

In this article we know that are life insurance payouts taxable? The primary purpose of life insurance is to provide a death benefit that can take care of your loved ones financially. A bonus is that life insurance death benefits aren’t typically taxed. Since coverage amounts can be very high—into the millions—it’s a major advantage that the life insurance payout is paid tax-free.

But there are some aspects to life insurance that won’t get past the taxman.

Are Life Insurance Payouts Taxable?

Life insurance death benefit payouts are usually not taxable. That means beneficiaries will receive the money without a tax burden hanging over their heads.

However, there are certain situations where a life insurance death benefit may be taxable. Here’s a look at when to prepare for a tax bill.

You Are a Life Insurance Beneficiary Who Receives Interest on a Death Benefit

Most life insurance payouts are made in one lump sum right after the death of the insured person. But if a beneficiary chooses to delay the payout or take the payout in installments, interest may accrue. In that case, the interest paid to the beneficiary may be taxed.

The Life Insurance Payout Goes Into a Taxable Estate

Most life insurance payouts are made tax-free directly to life insurance beneficiaries. But if a beneficiary was not named, or is already deceased, where does the life insurance death benefit go? It goes into the estate of the insured person and can be taxable along with the rest of the estate.

This could create a significant tax bill, especially considering both federal and state estate taxes may be applied. While federal estate taxes will not tax the first $12.92 million per individual as of 2023, state estate taxes can have significantly lower exemption levels.

Another possible unhappy scenario is that an estate is below the exemption level but a large life insurance payout to the estate pushes it above the exemption threshold into taxable territory.

This is avoidable by naming both primary and contingent life insurance beneficiaries and keeping those selections up to date.

The Life Insurance Policy Involves Three Different People

Life insurance death benefits can become a taxable gift in a situation where three people serve three different roles in connection with the life insurance policy. The positions include:

• The policy owner. This is the person who purchased the policy and is ultimately responsible for paying the premiums.
• The insured. This person’s life is covered by the life insurance policy.
• The beneficiary. This person receives the death benefit when the insured person dies.

For example, say a husband purchases a life insurance policy for his wife, and their son will be paid the death benefit. Suppose the wife (the insured) dies and the son (the beneficiary) receives the death benefit. In that case, the IRS considers the life insurance payout a gift from the husband (the policy owner) to the son. This is sometimes referred to as the “Goodman triangle” or “Goodman rule,” named after a decades-old court case regarding this issue (Goodman v. Commissioner of the IRS).

If this triangle exists, the policy owner may have to pay gift tax for the life insurance payout that exceeds federal gift tax exemption limits. In 2023, the annual gift exclusion is $17,000 per individual and the lifetime limit (known as a basic exclusion) is $12.92 million per individual.

To avoid tax implications from the Goodman triangle, limit insurance policy involvement to only two people: a policyholder who is also the insured and the beneficiary. A remedy to the example above is for the wife to be the policy owner and insured, maintaining the son as the beneficiary.

Is the Cash Value in a Life Insurance Policy Taxable?

If you have a cash value life insurance policy, like whole life insurance, you can generally access the money through a withdrawal, a loan or by surrendering the policy and ending it.

One of the reasons to buy cash value life insurance is to have access to the money that builds up within the policy. When you pay premiums, the payments generally go to three places: cash value, the cost to insure you and policy fees and charges. Money within the cash value account grows tax-free, based on the interest or investment gains it earns (depending on the policy). But once you withdraw the money, you could face a tax bill.That is  why life insurance payouts taxable.

Money that’s withdrawn from cash value is generally made up of two parts:

If your life insurance policy is a “modified endowment contract,” or MEC, different tax rules apply and it’s best to consult a financial professional to understand tax implications.

You Surrender the Life Insurance Policy

There can be times when a policy owner no longer wants or needs the life insurance policy. You can take the surrender value of the life insurance policy and the insurer will terminate the coverage. The amount you receive is your cash value minus any surrender charge. You can generally expect to get a surrender charge within the first 10 or 20 years of owning the policy, and over time the surrender charge phases out.

You won’t be taxed on the entire surrender value, though. You’ll be taxed on the amount you received minus the policy basis, or the total premium payment you made on the policy. This taxable amount reflects the investment gains that you took out.

Say the premiums you’ve paid over many years add up to $38,000 and your total cash value is $45,000. The portion of the payout that would be taxed is $7,000, representing the investment gains.

You Took Out a Policy Loan and the Life Insurance Ends

If you have a policy with cash value and take a life insurance policy loan against it, the loan isn’t taxable—as long as the policy is in force. But if the policy terminates before you’ve paid the loan back, you could get a tax bill. For example, the coverage terminates if you surrender the policy or it lapses.

The taxable amount is based on the amount of the loan that exceeds your policy basis. Policy basis is the portion you’ve paid in premiums. Amounts “above basis” are based on interest or investment gains on cash value.

One way to access all your cash value and avoid taxes is to withdraw the amount that’s your policy basis—this is not taxable. Then access the rest of the cash value with a loan—also not taxable.

If you die with a loan against the policy, the death benefit is reduced by the outstanding loan amount.

You Sell the Life Insurance Policy

There’s a market for existing life insurance policies, especially cash value life insurance policies that insure people who are terminally ill or have short life expectancies. Transactions involving terminally ill policy owners are called “viatical settlements.” These involve an investor, such as a company specializing in buying policies, paying you money for the policy, becoming the policy owner and then making the life insurance claim when you pass away.

Viatical settlements are typically used as a way for patients to get money for medical bills, especially when selling a life insurance policy will mean getting more money than simply surrendering it for the cash value.

Fortunately, the IRS doesn’t treat any portion of what you receive for a viatical settlement as taxable. Under IRS code 101(g)(2), an amount paid by a viatical settlement provider is treated like a payment of the death benefit—and death benefit payouts are not taxable.

A life settlement is a similar transaction but involves a policy owner who is not terminally ill. In these cases, the IRS does not see the proceeds as a payment of death benefit. A portion of what you receive can be taxable.

Our Conclusion:  Life Insurance Payouts Taxable?

 

Life insurance can be a valuable tool for business, personal and estate planning as it enables quick and easy transfer of assets when a person passes away. Plus, it offers tax-favorable cash value accumulation as well as access to the cash value in the policy.

When you are looking to use life insurance as a planning strategy, don’t leave it solely to the IRS to dictate your taxation. There is significant value in working with professionals to help guide the proper plan for you as well as a qualified tax advisor to help make sense of any tax implications for your situation.