Are Life Insurance Payouts Taxable?

A life insurance policy is a contract between a policyholder and an insurer that guarantees the payment of a death benefit to the beneficiaries upon the death of the policyholder. The death benefit is generally paid out tax-free to the beneficiaries. However, there are certain situations where life insurance payouts may be taxable. In this article, we will examine the circumstances under which life insurance payouts are taxable and provide answers to frequently asked questions.

When are Life Insurance Payouts Taxable?

The general rule is that life insurance payouts are not taxable. However, there are several situations where life insurance payouts may be subject to income tax or estate tax:

  1. When the policyholder has named their estate as the beneficiary of the policy
  2. When the policy has been sold or transferred for valuable consideration
  3. When the policyholder has borrowed against the cash value of the policy and the policy lapses or is surrendered
  4. When the policyholder has purchased a modified endowment contract (MEC) and withdraws funds from the policy

Let us discuss these situations in more detail below:

When the Policyholder has Named their Estate as the Beneficiary of the Policy

If the policyholder has named their estate as the beneficiary of the policy, then the death benefit will become part of the estate and may be subject to estate tax. The estate tax is a tax on the transfer of property from a deceased person’s estate to their heirs. The IRS sets an exemption limit each year, and if the value of the estate exceeds the exemption limit, then the excess is subject to the estate tax.

For example, if the value of the estate is $5.5 million and the current exemption limit is $11.58 million, then the estate would owe estate tax on the $4.08 million in excess of the exemption limit.

When the Policy has been Sold or Transferred for Valuable Consideration

If a life insurance policy has been sold or transferred for valuable consideration, then any death benefit paid out may be subject to income tax. Valuable consideration refers to anything of value that is given in exchange for the policy, such as money, property, or services.

For example, if a policyholder sells their life insurance policy to a third party for $50,000, and the policy has a death benefit of $100,000, then any death benefit paid out would be subject to income tax up to the amount of the gain realized on the sale.

When the Policyholder has Borrowed Against the Cash Value of the Policy and the Policy Lapses or is Surrendered

If a policyholder has borrowed against the cash value of their life insurance policy and the policy lapses or is surrendered, then any remaining loan balance may be subject to income tax. The loan balance is treated as income to the policyholder, and they will owe tax on the amount of the loan balance that exceeds the premiums paid into the policy.

For example, if a policyholder borrowed $20,000 against the cash value of their policy, and the policy lapsed or was surrendered with a remaining loan balance of $10,000, then the policyholder would owe income tax on the $10,000 loan balance as it exceeded the premiums paid into the policy.

When the Policyholder has Purchased a Modified Endowment Contract (MEC) and Withdraws Funds from the Policy

If a policyholder has purchased a modified endowment contract (MEC) and withdraws funds from the policy, then any withdrawals may be subject to income tax or penalty tax. A MEC is a type of policy that has been funded with more than the allowable amount under IRS rules. If a policy is classified as a MEC, then any withdrawals may be subject to a penalty tax of 10% if the policyholder is under age 59 ½ and has not held the policy for at least five years. Additionally, any withdrawals may be subject to income tax.

FAQs

Q: Is the death benefit of a life insurance policy taxable?

A: The death benefit of a life insurance policy is generally not taxable. However, there are certain situations where the death benefit may be subject to income tax or estate tax.

Q: Are life insurance premiums tax-deductible?

A: No, life insurance premiums are not tax-deductible. Life insurance is considered a personal expense and is not deductible on your income tax return.

Q: Can I avoid estate tax on the death benefit of my life insurance policy?

A: Yes, you can avoid estate tax on the death benefit of your life insurance policy by naming individual beneficiaries rather than your estate as the beneficiary. If you name an individual beneficiary, then the death benefit will pass to them directly and will not become part of your estate.

Q: How can I avoid income tax on the gain realized from the sale of my life insurance policy?

A: To avoid income tax on the gain realized from the sale of your life insurance policy, you can consider a life settlement. A life settlement is the sale of a life insurance policy to a third party for more than the policy’s cash surrender value but less than the death benefit. The proceeds from the life settlement are generally tax-free up to the amount of the premiums paid into the policy.

Q: What is the difference between a MEC and a non-MEC life insurance policy?

A: The difference between a MEC and a non-MEC life insurance policy is the amount of premiums paid into the policy. A MEC is a policy that has been funded with more than the allowable amount under IRS rules. If a policy is classified as a MEC, then any withdrawals may be subject to income tax or penalty tax. A non-MEC policy is a policy that has been funded within the allowable limits, and any withdrawals are generally tax-free up to the amount of the premiums paid into the policy.

Conclusion

Life insurance payouts are generally not taxable. However, there are certain situations where life insurance payouts may be subject to income tax or estate tax. By understanding these situations and planning accordingly, you can ensure that your loved ones receive the maximum benefit from your life insurance policy.