In most cases, life insurance is not subject to taxes, but some exclusions exist. Before going through all instances where you pay taxes, let’s look at when you don’t pay taxes on life insurance.
When Is Life Insurance Not Taxable?
When your beneficiary gets payment in a lump sum
Your beneficiary pays no income taxes when they receive a payout (death benefit) for your life insurance. No matter how big the payment is, no taxes will be paid.
If the death benefit is considered part of the estate and the payment is below a certain limit, no estate taxes are also paid. As of 2019, $11.4 million is the limit. If you don’t pick a beneficiary, your death benefit is considered part of the estate.
When your beneficiary gets a gain in cash value
If you opt for cash-value life insurance, your beneficiary might receive a gain in cash value when you die. It is not a must your beneficiary will receive a gain in cash value, but if the insurance company decides to sell a policy that pays out some cash value, they will. Your beneficiary won’t pay taxes on the amount he receives unless the amount surpasses the total amount you paid into the policy over the years.
When you make a partial withdrawal from the cash value of permanent insurance
Partial withdrawals you make from the cash value portion of your policy are non-taxable. But remember that if you don’t pay back those withdrawals before your death, they will be taken from the death benefit before your beneficiaries get anything. In a nutshell, any partial withdrawal you make and fail to pay back reduces the provision your family will get when you die.
When you receive annual dividends
Cash dividends in mutual insurance companies are shared based on the company’s profit among policyholders. If you are a policyholder in such a company, your dividends are tax-free as long as they do not exceed what you have paid out in premiums when added to the cash value amount.
In case you surrender your permanent life insurance policy
If you decide to turn in an expensive permanent life insurance policy for an affordable term life insurance policy, accumulate a small amount in your cash value. Your insurer will give you a lump sum, which is not taxable unless the sum is larger than what you have paid.
When you accelerate your death benefit
You also don’t pay taxes when you accelerate your death benefit. One instance where you accelerate your death benefits is when you become terminally ill. In such a case, you are considered your beneficiary and thus qualify to receive your death benefit early. Your request must be served within two years of your death. You don’t pay taxes because the amount you get follows the standard beneficiary rules. If you choose this path, ensure your beneficiaries are taken care of in other ways.
The value is built over time but is not subject to a capital gains tax
With a permanent life insurance policy, you can build value over time. This is what happens. For every monthly premium you pay, a portion is set aside for cash value, and the balance is put toward administrative tools and the actual policy. The insurer then invests the cash value. This means it has grown over the years. Although it is a growing investment, you should not pay a tax on the earnings.
When is life insurance taxable?
There are instances when taxes are unavoidable when receiving a death benefit. Let’s have a look at those moments when taxes are payable on the death benefit of a life insurance policy.
When three people are involved
In reality, there are three roles in a life insurance policy. That is the owner of the policy, the insured person, and the beneficiary. If only two people are involved, the policy is non-taxable. For example, no taxes are paid if the owner is the covered person. But if the owner (father) insures the son and names the daughter-in-law as the beneficiary, the death benefit is subject to taxes for the daughter-in-law.
When your estate surpasses the estate tax threshold
If you don’t name a beneficiary, your death benefit is counted as part of your estate and is subject to taxes if the figure exceeds $11.4 million. Check your state laws, as some states have additional estate tax requirements.
When you gain from surrendering your cash value policy
You receive payment from your cash-value account when you surrender a permanent life policy for a cheaper term life policy. If you get more than the total premiums you have paid, you will pay taxes on the extra income.
When you sell a life insurance policy
You also pay income taxes when you sell your permanent life insurance. Remember that any broker selling on your behalf will take a fraction of the amount you receive. Don’t expect to get an amount equal to the death benefit. You will get less than that; if the amount is more than the total premiums you have paid, you will not evade income tax.
Can you use an irreversible trust to shield your death benefit from taxes?
Yes, it is possible to use an irrevocable trust. For example, you can name a beneficiary in the life insurance policy as an unchangeable trust. By doing that, the life insurance payment will not be considered part of the insured’s estate. This further lowers the estate value and the possibility of estate taxes.
Below are ways you can look at taxes and trust:
- Suppose you set up the irreversible trust from the start as the owner and the beneficiary of the life insurance policy. In that case, the death benefit automatically is in force with no taxes due from that day.
- If you set up the trust and transfer the policy into the trust later, a three-year wait period comes into play to prevent people from taking advantage of the last minute to avoid taxes.
Life insurance payment: Installments or full?
Payouts can be paid in installments or in full. If paid in installments, the interest accumulating on the payments is taxable. The death benefit remains non-taxable. Installments are ideal for individuals who fear spending the lump sum all at once.