While not the originator of the phrase, Benjamin Franklin once wrote: “In this world nothing can be said to be certain, except death and taxes.” Life insurance helps us prepare for death, but what about the uncertainty caused when life insurance and taxes overlap? How exactly do they interact, and what do you need to know to keep yourself on the straight and narrow?
You’ve heard about when lottery winners get all that cash at once and then spend a huge chunk of it paying taxes on the gain. You might be worried the same is true if and when you receive a life insurance payout.
Whatever your specific situation, you’ll definitely want to talk to a licensed tax professional. But in this article, we want to ease any worries or fears by giving you some information on taxes and how they relate to life insurance.
Types of Taxes You Need to Know
First, let’s get a handle on the different types of taxes we’re talking about here.
Income Tax – This is the most widely known tax of the four, and is simply a federal or state tax on the income of an individual or married couple. The Internal Revenue Service (IRS) takes the amount you’ve gained during the year, allows you to deduct certain expenses, and finally determines what you owe based on your net income tax bracket.
Estate Tax – Basically, the federal government and some states combine all the assets of the deceased (property, investments, annuities and life insurance), subtract all that is owed (loans, medical bills and credit cards), and then they tax the final number. This tax is paid from the estate itself, not the individuals involved. The good news is most estates are not affected by this federal tax because, as of 2019, only those estates valued over $11.4 million have to pay. Each state that has an estate tax also has its own exemption amount ranging anywhere from $1 million to $11.4 million.
Inheritance Tax – An inheritance tax is a bit different because it is state tax put on a person who receives an inheritance. All spouses are exempt from this tax, but some states will tax children or domestic partners. Since it’s so rare, you’re probably not affected by it, but go ahead and check to see if you live in one of the six states that has an inheritance tax.
Generation-Skipping Tax – This one might be a no-brainer if you look closely at the term. Basically, it’s a tax applied when an inheritance is given to someone other than the next immediate descendant, or a “skip person,” whether that person is in the family or not. For example, a grandfather could “skip” his own child and leave an inheritance to his granddaughter (or a relative who’s at least 37½ years younger than the deceased).(1) This tax can also be applied to money given to a skip person through a trust.
When Is Life Insurance Not Taxable?
Most of the time, life insurance is not taxable. But there are some exceptions. We want to put your mind at ease first by highlighting some specific instances where you don’t have to worry about taxes on life insurance. We’ll talk more about when you do have to pay later.
When Your Beneficiary Gets a Payout in a Lump Sum
No surprise here—when your spouse or other designated beneficiary is given the payout (called the “death benefit”) for your life insurance, no matter how big it is, no income taxes are paid.
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If the death benefit is considered part of your estate (because you didn’t stipulate a specific beneficiary), and the payout is below a certain limit ($11.4 million in 2019), no estate taxes are paid.
When Your Beneficiary Receives a Gain in Cash Value
If you have cash value life insurance (as opposed to term life insurance, which is the type we recommend), you have an added cash value account associated with it. When the policy holder dies, the full cash value goes back to the insurance company (see why we don’t recommend this type of policy?). In some very rare cases, an insurance company will agree to sell a policy that pays out some cash value to the beneficiaries upon your death. The beneficiaries still won’t pay income tax unless the amount they receive exceeds the total amount you’ve paid into the policy over the years, which is highly doubtful.
When You Make a Partial Withdrawal From the Cash Value of Permanent Insurance
While you’re still living, you can make a partial withdrawal from the cash value portion of your policy, and this amount is not taxable. Now, if you don’t pay it back before your death, that amount will be subtracted from the death benefit before your beneficiaries receive a dime. In a way, you’re cannibalizing your life insurance by eating away at the provision you’ve established for your family.
When You Receive Annual Dividends
Some insurance companies are called “mutual” insurance companies because they’re structured so that the policyholders own the company “mutually.” In this case, the shared owners will receive cash dividends based on the profit of the company. These dividends are not taxable as long as when they are added to the cash value amount, they do not add up to more than what you’ve paid out in premiums that year.
When You Surrender Your Permanent Life Insurance Policy
Say you do your research and decide to turn in, or “surrender,” your permanent life insurance policy for a less expensive term life insurance policy. You may have accumulated a small amount in your cash value account. You’ll be given a lump sum from the insurance company, but you won’t have any taxes to pay unless this sum is larger than what you’ve paid in (but don’t hold your breath).
When You Accelerate Your Death Benefit
If you’re up against a wall because you become chronically or terminally ill, you may have the option to “accelerate” your death benefit. Essentially, you’d be considered your own beneficiary, and you’d receive your death benefit early. You only want to choose this path if you know your loved ones are going to be taken care of some other way. After all, they’re the reason you got life insurance in the first place.
It may sound a bit morbid, but the one stipulation is that your request must come within two years of your death. The amount received is normally not taxed because it follows the same beneficiary rules—almost as if you’re a normal beneficiary of your own life insurance policy.
When Is Life Insurance Taxable?
Most of the time, you’re free and clear of taxes when receiving a death benefit. But once in a blue moon, you’ll find occasions when taxes kick in and must be paid on the death benefit of a life insurance policy. Here are a couple of those instances.
When Three People Are Involved
When you think about it, there are really only three roles in a life insurance policy: the owner of the policy, the insured person and the beneficiary. If there are only two people in this scenario, the policy is not taxable. For example, if the owner is the insured person, there’s no tax! But if a father (the owner) buys a life insurance policy on his son (the insured), then names his daughter-in-law as the beneficiary, the death benefit is taxable income for the daughter-in-law.
When Your Estate Exceeds the Estate Tax Threshold
If your spouse or children are named as the beneficiaries of your life insurance, the death benefit is not counted as part of your estate. But if it’s paid to a skip person (see above) or not specified, it will be included in the value of your estate. Your “taxable estate” is calculated by taking this estate value and subtracting any unpaid loans from the cash value account. If this figure is over $11.4 million, the estate will have to pay taxes. Remember to check with your state laws too, because some have their own estate tax set up.
When You Sell a Life Insurance Policy
If you decide you no longer need permanent life insurance and want to sell it (usually to an investment company), keep this in mind: The agent or broker selling it on your behalf will take a cut from the amount you receive. And don't expect to get back the amount you're covered for when you die (the death benefit). You'll get back less than that, and if the amount you do receive totals more than all the premiums you've paid over the years, you'll pay income tax on it.
When You Profit From Surrendering Your Cash Value Policy
After buying a replacement term life policy, getting the payout from your cash value account, and then surrendering your permanent life policy, you may owe taxes. If the amount you receive is more than what you’ve paid in fees and premiums over the life of the policy (fat chance!), you’ll need to report that amount as extra income. But this hardly ever happens.
Note: The order here is important. You never want to be even a moment without insurance coverage. Don’t worry if you’re double-covered for a few days with both whole and term insurance. Make sure the term is in force before surrendering your whole life and receiving the cash value amount.
Can I Use an Irrevocable Trust to Shield My Death Benefit From Taxes?
Some people with larger estates may consider naming the beneficiary in their life insurance policy as an irrevocable trust. This way, the life insurance payout will not be considered part of the estate of the insured, which lowers the estate value and the potential for estate taxes.
The trust itself has its own tax ID number and will receive the death benefit directly at the death of the insured. Afterward, the trustee of the trust will distribute the funds to the beneficiaries named in the trust. Even a “skip person” will escape paying income taxes on the trust assets they receive.
Here are two ways to look at trusts and taxes:
If you set up the irrevocable trust from the beginning as the owner and the beneficiary of the life insurance policy, then the death benefit is in force with no taxes due from day one.
If, however, you set up the trust and transfer the policy into the trust, a three-year implementation period comes into play to prevent people from undertaking last-minute sneakiness to avoid taxation.
If you can set up a trust so that all the i’s are dotted and the t’s are crossed, it’s all good. It will be available for your heirs to use to pay any estate taxes on your other assets. But it’s really not practical except for estates worth over the magic number of $11.4 million (as of 2019) and should be set up by an estate law professional who does this all the time.
Are Life Insurance Premiums Tax Deductible?
Uncle Sam considers your monthly premiums a personal expense, so they can’t be deducted when calculating your taxable income. They can’t be paid using your Heath Savings Account (HSA) either. Good try, though!
When push comes to shove and you want to get some professional eyes on your specific tax situation, you’ll want to talk to somebody who wades through these issues day in, day out. We’ve vetted some of the best tax pros in the country and can even recommend a local one close by. Do yourself a favor and lay it all out with a competent tax pro.
Life insurance also has a boatload of options. We’ve talked about a ton of them here, but when you’re ready to toss your permanent insurance policy and get a term policy, get help from a professional. When you’re ready, contact the company Dave Ramsey trusts and recommends—Zander Insurance.
We’ll leave you with another quote from Ben Franklin urging you to act soon on what you just learned: “One today is worth two tomorrows; never leave that till tomorrow which you can do today.” Thanks, Ben!