Do you have to Pay Taxes on Life Insurance?

Although life insurance proceeds are not generally taxable as income they can be subject to tax as part of your estate if it exceeds the federal and state exemptions. If you choose to dispose of your policy via a settlement or surrender it to your insurer, you may be subject to income and capital gains tax.

Is the Life Insurance Proceeds Taxable

The proceeds of life insurance are not subject to income tax if they are paid in a single lump sum. The insurer will usually pay interest if the beneficiary receives the life insurance payout in installments. If their beneficiary is a child or dependent on their income, parents will often ask for their life insurance death benefit to be paid in installments. Your beneficiary would be subject to income tax in these cases.

Estate taxes are a completely different matter. The executor of your estate must file IRS Form 712 when you die. This form is part of your estate tax returns. The value of your life insurance policies is determined by when you die. Form 712 shows this. Your spouse will receive your beneficiary life insurance payout without tax. They will also inherit the remainder of your estate. Spouses are usually exempt from estate taxes.

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Your life insurance payout will usually be added to your estate if your beneficiary is not your spouse. If your estate total is less than the exemptions, this is acceptable. If your estate is worth more than the exemption, inheritance and estate taxes will apply.

  • Federal Estate Taxes: A 40% estate tax will apply to estates exceeding $11.58million per person.
  • State Estate and Inheritance Taxes-There are 18 states plus D.C. that have an inheritance or estate tax. Although the exemption amount for estate taxes varies from one state to another, it is usually between $1 million and $2 million. Depending on where you live, tax rates can reach up to 20%.

Your life insurance policy will only be included in your estate for tax purposes. It would not be included as part of your estate for any other purposes such as payment creditors unless you designated the estate as beneficiary or all beneficiaries died.

An irrevocable life insurance trust (ILIT), can help you avoid estate taxes

An irrevocable trust for life insurance can be set up to prevent life insurance payouts from being subject to estate tax. The policy is transferred to the ILIT. You cannot be the trustee. You can choose who the trust beneficiary is.

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An ILIT is a great way to ensure that your life insurance death benefit does not become taxable. However, there are a few situations where you might be subject to a tax event.

  • If the cash value of the life insurance policy is higher than the gift exemption, then you might need to pay a gift taxes when transferring ownership. 2020’s gift tax exemption is $15,000.
  • The policy will become part of your tax estate if you die within three years of the transfer of the life insurance policy. This policy is meant to ensure that your heirs don’t pay taxes by donating assets as deathbed gifts.

Are Life Insurance Life Benefits Taxable?

Life insurance policies often offer the possibility of having a portion of your death benefit increased if you are diagnosed with a terminal or chronic illness. This is a useful option as severe illnesses can often result in high hospital and treatment expenses. It’s usually not tax-deductible if you have a terminal illness. It’s basically a benefit that you receive from life insurance.

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Taxes on Life Insurance Dividend payments & Cash Value

You may be eligible for periodic dividends if you have permanent insurance from an insurance company. The policyholders of mutual insurance companies are the owners. Therefore, the company may distribute excess income as annual dividends. Life insurance dividend payments aren’t taxable unless the dividend amount exceeds what you paid in premiums.

Permanent insurance policies also allow you to pay premiums and a portion of that goes toward the policy’s cash worth. The cash value is basically how much money you would get if the policy was canceled. It is subject to the policy terms’ interest rates and is tax-deferred.

The insurer can provide a tax-free loan with the policy’s cash as collateral. However, the loan must not exceed the cash value. If the loan amount exceeds cash value, your policy could be canceled and you would need to pay taxes.

Transfer for Value Rule and Taxes on Life Insurance Settlements

You may be eligible for a settlement if you have a life policy and decide that you don’t need it anymore. A settlement in life insurance pays a third party a set amount to be the policyholder and beneficiary and takes over payments.

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The transfer for value rule basically states that if you die, your third party will have to pay taxes on your life insurance death benefit. They don’t have to pay income taxes on the entire amount. The death benefit less any value paid to you and any premiums paid since the policy was acquired would be the taxable amount.

You, the seller, would be subject to tax on the sale your life insurance policy. The income portion of your life insurance settlement is taxable, while capital gains are taxed. Here are some guidelines to help you estimate how a life insurance settlement will be taxed.

  • Portion Taxed As Income – This is the policy’s cash amount minus the premiums paid. This figure would be zero since term insurance policies do not have a cash value.
  • Portion subject to Capital Gains Tax – To determine your total settlement gain, subtract the premium you paid from the settlement. To determine the capital gains taxable portion, subtract the amount subject to income tax from the settlement.
  • Example: Let’s say you sell your life insurance policy with a cash value $150,000 and a $200,000 settlement. You had also already paid $125,000 in premiums. Because the difference in the cash value of the policy and the premiums you paid is greater than the policy’s cash value, $25,000 would be income. The premiums paid are subtracted from the settlement to calculate the capital gains tax. This leaves you with $75,000. Next, subtract the $25,000 income tax amount. Capital gains tax would apply to the $50,000 remaining.
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Tax consequences of surrendering your life insurance policy

If you surrendered your life insurance policy, or were unable get a settlement for it, the cash value of the policy would determine if you had to pay taxes. If the cash surrender value of your life insurance policy was less than what you paid in premiums, there would be no taxes. The cash surrender value must be greater than the premiums paid. If it is, it will be taxable as income.

The surrender of term life insurance policies doesn’t incur taxes because they don’t have cash value. You would not receive any money from the insurance company.

Is it possible to deduct taxes from life insurance payments?

Life insurance premiums that are paid by an individual policy are not deductible. They are treated as any other expense.

Group term insurance policies are typically offered by employers or associations. They can be different. Employers can deduct premiums for life insurance coverage up to $50,000 per employee provided that the employer is not the beneficiary. You can add the cost of group and supplemental life insurance to your taxable income as an employee or member of an association.

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You won’t have to pay tax on any life insurance that you have, provided you have no more than $50,000 in group or supplemental term. The IRS will assign a fair market value to coverage above $50,000 based on your age. The fair market value is the amount that you pay in premiums. The difference is considered taxable income. Although it may seem strange to pay taxes for coverage you have already purchased, this rule is intended to allow for situations in which you get a lower rate when you purchase group life insurance. Group coverage means that risk is shared across many people. This can mean that if you are very sick or elderly, you might get a lower rate than you would with an individual policy.