In addition to protecting your dependents from financial hardship, life insurance policies are shielded from taxation under most circumstances.
A death benefit is considered to be the reimbursement for a loss, not income. That means when a beneficiary receives an insurance payout, the proceeds normally don’t need to be reported for tax purposes.
There are circumstances when the government may levy a tax against life insurance, but this usually occurs only with permanent life policies or with beneficiaries who have high-value estates, says Adam Beck, an assistant professor at the American College of Financial Services in Pennsylvania.
When Are Life Insurance Proceeds Tax Exempt?
Here are some of the situations in which life insurance is protected from taxation:
- Increases in cash value. Permanent or “cash value” life insurance policies are designed to increase in value through investments. The increase in value isn’t counted as income, and is exempt from taxation.
- Lump-sum payments. Permanent life insurance policyholders have the ability to surrender their policies for lump-sum payments. If a lump sum is less than the money you put into the policy, it’s not taxable.
- Investment dividends. Mutual insurance companies may return money to policyholders as dividends. These policyholders can’t be taxed until the amount exceeds what the insured has paid out in premiums.
- Payments to a spouse. Life insurance payments to a spouse typically aren’t subject to federal income taxes or estate taxes.
When Is Life Insurance Taxable?
Here are some situations in which the government may claim a share of life insurance benefits:
- Life insurance settlement profits. If you sell your life insurance policy, the buyer will pay the premiums and receive the cash benefit upon your death. The money you get from selling your policy may be taxed. The way it is taxed will depend on the type of policy, the money you paid into it, the amount you received from selling it, and whether there was any cash value.
- Earnings from a permanent life policy. If you surrender a permanent life policy and the lump-sum value is greater than the amount you have paid into it because of investment returns, you may have a tax bill. The difference is considered taxable at ordinary income tax rates, explains Patrick Ritter, a financial planning consultant at Fiduciary Advisors in St. Louis.
- Outstanding loans. If you’ve borrowed money against your cash value policy or you’ve allowed it to lapse, you’ll have to pay taxes on any outstanding loan balance that exceeds what you paid into the policy.
- Payouts that are part of a large estate. For the wealthy, life insurance can be subject to the federal estate tax. If the estate is large enough to be taxed, the life insurance payout may be taxed as well, Beck explains. Estate tax applies to estates worth more than $5.45 million for 2016. Some people use irrevocable trusts to prevent their insurance proceeds from becoming part of a their estate.
Preventing Life Insurance Taxation
In cases where estate taxes are likely to be paid, some people take out polices on their lives designed to provide money for their heirs to pay those taxes. In some cases, wealthy people are able to avoid estate taxes by combining permanent life insurance policy with an irrevocable trust. Placing ownership with the trust removes the death benefit from the value of the estate.
The goal is to prevent insurance proceeds from raising the estate’s value beyond the threshold that triggers estate taxes. The trust, not the insured, owns the life insurance policy. The trust pays premiums and distributes money to beneficiaries when the insured person dies.
Tax laws are complex and they frequently change. Before you attempt to use life insurance to reduce your tax burden, consider consulting a financial planner.