Are Life Insurance Distributions Taxable?

are life insurance distributions taxable

are life insurance distributions taxableWhen you are considering your estate and what you are passing to your loved ones, it is important to consider the tax implications.

If you are leaving a large estate, you don’t want to leave your beneficiaries in the position of needing to sell it off in order to cover the inheritance tax on the estate.

Similarly, you don’t want to leave your loved ones a death benefit to cover important expenses only to have most of it eaten up in tax.

Fortunately, death benefits usually aren’t taxable. We say usually, as there are a few common mistakes people make that trigger tax liability on your death benefit and leave loved ones with an unexpected tax bill.

Read on to learn everything you need to know about life insurance distributions and tax, and how to avoid incurring tax on your policy.

Death Benefit And Inheritance Tax

A death benefit paid to an individual beneficiary is not subject to inheritance tax. For this reason, many people with large estates will take out life insurance specifically to cover inheritance tax, so that their estate will not need to be broken up and sold to cover the tax. You can read more about this strategy here.

The limit on the size of your estate before you would need to start paying inheritance tax depends on the state you live in. You can see your state’s inheritance tax limits here.

This inheritance tax is charged on the overall size of the estate, so it cannot be avoided by breaking the estate up into smaller portions and allocating it to different individuals. The estate as a whole needs to pay the inheritance tax before passing on what remains to the inheritors.

But, this means that one of the biggest mistakes you can make with life insurance is leaving it to your estate rather than an individual beneficiary. This increases the value of your overall estate, and includes the new money from your life insurance distribution in the overall taxable value of the estate. Therefore, you lose the benefit of excluding your death benefit from the inheritance tax.

If you do not want to leave your death benefit to an individual, you can get around this by creating an Irrevocable Life Insurance Trust (ILIT), which can then receive the benefit separately from your estate. However, bear in mind that you may not be a trustee of the trust, or have any rights to revoke the trust, for it to be considered a legal entity.

IIf you are the owner of the insurance policy, you can still change the amount of money that the ILIT is to receive, or transfer your benefit to a different person if you choose.

But, even if you have a trust set up, if you die within the first three years of the life insurance policy, the death benefit will still be included in your estate and add to the taxable level of your estate.

Death Benefits And Gift Tax

Similarly, gift tax may apply to the death benefit if it is paid out to a third party.

Gift tax can be incurred if the death benefit is above the $15,000 limit for gifts. Rates range from 18 to 40% depending on the size of the gift. Gift tax is usually paid by the giver, so the tax will need to come out of the benefit or the estate.

So when does gift tax apply to life insurance?

All life insurance policies involve three parties: the person whose life is insured, the person who pays the premiums (who is considered the owner of the policy), and the beneficiary who will receive the death benefit. If two of these people are the same person, there is no tax on the income, but if the policy involves three different people, a gift tax may apply.

For example, if you are the person who is insured and you are paying the premiums, there is no gift tax on the death benefit. If your partner is the insured person, but you are the owner of the policy paying the premiums and the beneficiary, there will be no gift tax when you receive the death benefit. However, if your partner is the insured person, you are the owner of the policy, and your grandchild is named as the beneficiary, there will be a gift tax when the grandchild receives the death benefit.

For this reason, the best thing to do is ensure that the person who is insured and the owner of the policy are the same person, even if another person provides the money to make premium payments. Those payments should look like they are coming from the owner of the policy.

Life Insurance And Taxable Income

When a beneficiary receives a death benefit payout from a life insurance policy, the money is not usually included in their taxable income, so it will not suddenly push them up into a new tax bracket and set the IRS on their tail.

However, if the beneficiary earns interest on the benefit, either while it is still in the hands of their insurance provider due to a delayed payout or as a result of their own investments, they will need to pay tax on any interest earned.

Living Benefits And Tax

If you have a policy that includes living benefits, paid out to you in the event of being diagnosed with a chronic, critical, or terminal illness, you will not need to pay tax on the benefit you receive. It is treated in a similar fashion to a death benefit paid out to your beneficiary. You will only accumulate tax liability on any interest earned on the sum.

Cash Value And Tax

It is possible to access money from your life insurance policy while you are living through cash withdrawals, cashing in your whole policy, or selling your policy. These options only apply to permanent life insurance policies and have different cash implications.

Cash Value Withdrawals

Cash value is often included in permanent life insurance policies. Some of your premiums are placed in a cash accumulation account where it is invested. You can access this money through withdrawal and loan policies.

While most withdrawals from life insurance policies are tax-free, there are some things that can trigger tax liability. The most common trigger is if you take out money within the first 15 years of the policy and that withdrawal is high enough to reduce your death benefit. This will trigger tax liability.

You may also be liable for tax if your policy is considered a modified endowment contract. These are policies where the income from the policy exceeds federal tax laws, and tax liability can be triggered. This is because the cash you receive is considered to be made from interest first, rather than from your investments, so the money is treated as an annuity and therefore taxable.

Surrendering Your Policy

If you choose to surrender your entire policy for a cash value, you will also need to pay. Firstly, you will need to pay a fee for converting the policy into cash. After that, the gain on the policy is subject to income tax.

Selling Your Policy

You can also sell your policy to another individual or a life settlement company. The individual or company will keep your policy in force by paying the premiums and receive the benefit upon your death.

If you sell your policy for more than its final value, you need to pay ordinary income tax on the difference.

Conclusion

One of the benefits of life insurance is that the death benefit is not usually taxable. This means that you are not putting loved ones in an awkward situation financially when you leave them something through your life insurance, and you can even use life insurance as a way to cover inheritance tax due on the rest of your estate.

But in order to retain the tax-free nature of a life insurance benefit, you need to ensure that you have set up your policy correctly, and not accidentally done something that will trigger unexpected tax liabilities upon your death.

The easiest way to ensure your policy delivers what you intended is to be the owner of the policy yourself and pay the premiums yourself, and name any individual (or individuals) as your beneficiary rather than your estate or a trust.

You can learn more about life insurance and how it works here.