“Will my family have to pay taxes on my life insurance benefits?”
Life insurance is always received income tax-free, but see our article guide for other key considerations.
Quick Article Overview:
1. General Taxation of Life Insurance
2. Lump-Sum Payouts
3. Annuity Payouts (These Payments Include Interest)
4. Business Life Insurance
5. Estate Taxes
6. How to Avoid Estate Taxes
7. What if My Estate Isn’t Worth That Much?
The majority of the time a life insurance benefit is paid, it is paid out tax-free.
… but keep in mind there are several types of taxes, including:
- Federal Income tax
- State Income tax
- Estate tax
Turns out, it depends on HOW your beneficiary receives the death benefit (as a lump-sum or as an annuity) and the value of your estate.
Let’s take an example…
Life insurance typically pays out as a lump-sum. The amount of the lump-sum that is paid out to the beneficiary is the face amount of the policy, or the total amount of the insurance.
To break it down: if you are insured for a $500,000 dollar policy, your beneficiary will receive $500,000 if you pass away during the life of your policy, and this amount will generally not be taxed as federal or state income.
In What Situations Would My Beneficiaries Owe Taxes On The Life Insurance Payout?
Let’s examine a few exceptions to the general rule that life insurance proceeds are tax free.
Life insurance can be paid as annual payouts instead of a lump-sum. In this situation, some life insurance companies will pay interest to you while they are holding the balance of the death benefit pay-out.
Interest is considered to be income by the IRS anytime it is earned. If you gain any interest on the payout of your life insurance, this amount is taxable.
This will not decrease the amount that is paid out below the original coverage amount, however, you will only be taxed on the interest earned from this benefit not the benefit itself.
Life insurance premiums, if the policy is owned by a business entity, should generally be paid with after tax dollars. If the premiums are deducted, there’s a chance that the death benefit will be taxed as income.
A couple situations where life insurance should definitely NOT be deducted are:
- In the case of a business partnership, where one partner takes out a policy on the other
- Taking out a policy on a business owner to secure a loan
Be sure to see IRS Publication 535 for further explanation, and seek tax advice. We are not tax professionals and always recommend you consult with your tax professional here.
This means that if you were to pass away and your estate was valued at more than $11,200,000 (assets minus liabilities), your beneficiaries or whomever inherits your estate would owe estate taxes on the value of your estate that exceeds $11,200,000.
Example: if your estate is worth $12,000,000, and you pass away, the beneficiaries of your estate would owe taxes on $800,000 (12,000,000-$11,200,000). The current tax rate for estate taxes in 2018 is set at 40%. This would mean that 40% of $800,000 is $320,000.
In other words, $320,000 would be need to be paid to the IRS to by your beneficiaries to keep your estate whole.
Note: The estate tax exclusion is doubled in the case of married couples, so they can leave an inheritance of approximately $22.4 million before estate taxes would be due.
Another Note: Just because an estate is not subject to federal estate tax, doesn’t mean it won’t owe estate tax at the “state” level. Some states have exemption limits as low as only $1 million.
How does This Apply to Life Insurance?
If you own your life insurance policy, the payout from your life insurance is considered to be part of your estate.
Let’s say your estate is worth $10,500,000 and you have 1 million in life insurance, your estate would be valued at $11,500,000.
$10,500,000 + $1,000,000 = $11,500,000 (total estate value)
At your passing, your beneficiaries will be taxed the amount of your estate that exceeds the Estate Tax Exclusion amount ($11,200,000). In this situation, the taxable amount is 40% of $300,000.
$11,500,000-$11,200,000 = $300,000 (total taxable amount)
So technically in this situation, the proceeds of the life insurance would be taxed (estate taxes only, not income tax), and the amount owed would be $120,000.
$300,000 * 0.4 (40%) = $120,000 (total amount owed)
The easiest way to set this up correctly is to transfer the ownership of the policy to a family member.
If you are not in direct control of the ownership of the policy, it is not taxable. The downside to this however is that someone else is in control of your policy so you will want to make sure it is someone you trust.
Another way to set up your life insurance to avoid taxes, you will need to set up an irrevocable trust.
The Irrevocable Trust will become the owner of your policy, but once the irrevocable trust becomes the owner of your policy, you will not be able to make any changes to it.
In this situation, you must name a trustee for your irrevocable trust, you cannot be the trustee of your own irrevocable trust. In addition, the irrevocable trust must own the policy from the time it is purchased until you pass.
If you decide to transfer a life insurance policy that you currently have into an irrevocable trust, do not wait. The irrevocable trust must be the owner of your policy for at least 3 years at the time of death to avoid any estate taxes being assessed.
What If My Estate Is Not Worth More Than The Estate Tax Exclusion Amount Including My Life Insurance?
Only the amount of your estate that exceeds the Estate Tax Exclusion amount can be taxed, so if your estate including life insurance is not more than $11,200,000, your beneficiaries will not owe any taxes on the life insurance pay out.
Please keep in mind that the estate tax exclusion can change, and in while the exclusion has increased in the last few years, in 2015, the estate tax exclusion was set at $5,430,000. Three years earlier in 2012, the exclusion was $5,120,000. In addition, the tax rate for estate taxes may also change, and it recently increased from 35% to 40%.
If you need more information about life insurance, or if you would like to learn more about shielding your life insurance policy and estate from estate taxes, please give us a call, 855-247-9555 as we would be happy to help you out.
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