Life insurance is a crucial investment that provides financial security to your loved ones in your absence. However, most people don’t understand the taxation rules surrounding life insurance proceeds. This article aims to educate you on the taxable status of life insurance payouts and provide you with clarity on the subject.
Life Insurance Proceeds: What Does it Mean?
Life insurance proceeds refer to the sum of money paid out to the designated beneficiary upon the death of the policyholder. This money is tax-free and can be used to pay for funeral expenses, mortgages, credit card debts, and other financial obligations. However, certain circumstances may make life insurance proceeds taxable.
Is My Life Insurance Proceeds Taxable?
Generally, life insurance proceeds are not taxable. However, there are exemptions to this rule. Here are a few instances where life insurance payouts can be taxed.
When Are Life Insurance Proceeds Taxable?
When the Policyholder Receives Interest
If the policyholder owns a life insurance policy that accumulates cash value over time, the interest earned is taxable. The interest will be taxed as ordinary income in the year it was earned.
When the Proceeds are Paid Out in Installments
In certain cases, life insurance proceeds may be paid out in installments instead of a lump sum. If this happens, the interest earned on the installments is taxable.
When the Life Insurance is Part of an Estate
If the policyholder’s estate is worth more than the federal estate tax exemption ($11.7 million in 2021), the life insurance policy will be included in the estate. This means that the policy may be subject to federal estate taxes.
When the Policyholder’s Estate Owes Debts
If the policyholder’s estate owes debts or unpaid taxes, life insurance proceeds may be used to pay off these debts. This means that the beneficiaries may receive a reduced payout or no payout at all.
When the Policyholder Sells Their Life Insurance Policy
If the policyholder sells their life insurance policy to a third party, the proceeds from the sale are taxable as income. The amount of taxable income is the difference between the sale price and the policy’s cash surrender value (the amount the insurance company would have paid if the policy was surrendered).
How to Minimize Taxable Life Insurance Proceeds
If you want to minimize the taxable status of your life insurance proceeds, you can consider the following:
Transfer Ownership of the Policy
One way to avoid estate taxes is to transfer ownership of your life insurance policy to someone else. By doing this, the policy is no longer considered part of your estate and is not subject to estate taxes.
Set Up an Irrevocable Life Insurance Trust
An irrevocable life insurance trust (ILIT) is a trust set up specifically for holding a life insurance policy. By doing this, the life insurance policy is no longer considered part of your estate and is not subject to estate taxes.
Choose a Beneficiary Wisely
If you choose your spouse as your beneficiary, they will not have to pay federal income tax on the proceeds. However, if you choose someone else, they may be subject to federal income tax.
What happens if the life insurance proceeds exceed the estate’s debts?
If the life insurance proceeds exceed the estate’s debts, the remaining funds will go to the designated beneficiary as tax-free income
Are life insurance premiums tax-deductible?
No, life insurance premiums are not tax-deductible.
Can the beneficiary choose to receive the payout in installments to avoid taxes?
No, the interest earned on the installments will still be taxable.
In conclusion, life insurance proceeds are usually tax-free. However, certain circumstances such as accrued interest, policy sold for cash, or cash value accumulation may result in tax obligations. To minimize the taxable status of your life insurance proceeds, carefully consider your options and consult with a financial advisor or tax professional.