The main purpose of life insurance revolves around securing a financial lifeline for your loved ones in the event of your passing. An added benefit is that life insurance death benefits typically evade taxation. Considering the substantial coverage amounts that can reach into the millions, the tax-free nature of life insurance payouts stands as a significant advantage.
However, there are certain scenarios where the taxman might come knocking.
**Is a Life Insurance Payout Subject to Taxes?**
Normally, life insurance death benefit payouts remain exempt from taxation. This means that beneficiaries can receive the proceeds without the burden of taxes looming over them.
Nevertheless, there are specific situations where a life insurance death benefit may indeed be subject to taxation. Let’s delve into these circumstances.
**You’re a Life Insurance Beneficiary Receiving Interest on a Death Benefit**
While most life insurance payouts are typically issued as a lump sum immediately after the insured person’s demise, some beneficiaries may opt to delay the payout or receive it in installments. In such cases, interest might accrue, and this interest could potentially be subjected to taxation.
**The Life Insurance Payout Becomes Part of a Taxable Estate**
Most life insurance payouts are directed tax-free to the designated life insurance beneficiaries. However, if no beneficiary was named or if the named beneficiary is already deceased, the life insurance death benefit becomes part of the insured person’s estate and could be subject to taxation, along with the rest of the estate.
This situation could lead to a significant tax liability, especially when factoring in both federal and state estate taxes. Although federal estate taxes do not apply to the first $12.92 million per individual as of 2023, state estate taxes may have significantly lower exemption thresholds. Furthermore, a substantial life insurance payout to the estate could push it above the exemption threshold, resulting in a tax obligation.
This can be averted by naming both primary and contingent life insurance beneficiaries and keeping these selections up to date.
**The Life Insurance Policy Involves Three Different Roles**
Life insurance death benefits may be deemed a taxable gift when three individuals play distinct roles in relation to the life insurance policy:
– The policy owner, responsible for purchasing and paying premiums.
– The insured person, whose life is covered by the policy.
– The beneficiary, who receives the death benefit upon the insured person’s passing.
For instance, if a husband purchases a life insurance policy for his wife, with their son designated as the beneficiary, the IRS views the life insurance payout as a gift from the husband (the policy owner) to the son (the beneficiary) upon the wife’s (the insured) passing. This is sometimes referred to as the “Goodman triangle” or “Goodman rule,” stemming from a long-standing court case (Goodman v. Commissioner of the IRS) addressing this issue.
In the presence of this triangle, the policy owner might be required to pay gift tax for the portion of the life insurance payout exceeding federal gift tax exemption limits. In 2023, the annual gift exclusion stands at $17,000 per individual, with a lifetime limit (basic exclusion) of $12.92 million per individual.
To sidestep potential tax implications arising from the Goodman triangle, it’s advisable to restrict policy involvement to just two individuals: a policyholder who is also the insured and the beneficiary. A solution in the example mentioned earlier would be for the wife to assume the role of both policy owner and insured, while maintaining the son as the beneficiary.
**Is the Cash Value in a Life Insurance Policy Taxable?**
In the case of cash value life insurance policies, such as whole life insurance, you generally have the ability to access the accrued funds through withdrawal, loans, or policy surrender.
One of the incentives for investing in cash value life insurance is the access it provides to the accumulated funds within the policy. When you make premium payments, the funds typically split into three categories: cash value, insurance cost, and policy fees and charges. Money within the cash value component grows tax-free, depending on the interest or investment gains it accumulates (depending on the policy). However, withdrawing this money may result in a tax liability.
Here are situations where the cash value could become taxable:
**1. Surrendering the Life Insurance Policy:** If you no longer require or desire the life insurance policy, you can choose to surrender it and receive the surrender value. The insurer will then terminate the coverage. The amount you receive equals your cash value minus any applicable surrender charge. The surrender value is not entirely taxable. Taxation is applied only to the amount received minus the policy basis, which represents the total premium payments made on the policy. In essence, the taxable amount reflects the investment gains withdrawn.
**2. Taking Out a Policy Loan and the Policy Terminates:** If you have a cash value policy and obtain a life insurance policy loan against it, the loan remains non-taxable as long as the policy remains in force. However, if the policy terminates before you repay the loan, you might face a tax liability. For instance, policy termination occurs if you surrender the policy or if it lapses. Taxation is based on the portion of the loan exceeding your policy basis, which represents the premiums you’ve paid. Amounts exceeding the basis are calculated based on interest or investment gains within the cash value.
One strategy to access your entire cash value while avoiding taxes is to withdraw the portion equivalent to your policy basis, which remains non-taxable. Then, you can access the remaining cash value using a loan, which is also not taxable.
In the event of your demise with an outstanding loan against the policy, the death benefit is reduced by the loan amount.
**3. Selling the Life Insurance Policy:** There exists a market for existing life insurance policies, especially cash value life insurance policies covering individuals with terminal illnesses or short life expectancies. Transactions involving policyholders in these circumstances are referred to as “viatical settlements.” In viatical settlements, an investor, often a company specializing in policy acquisitions, provides you with a sum of money for the policy, becoming the new policy owner and eventually collecting the life insurance benefit upon your passing.
Notably, the IRS does not consider any portion of what you receive in a viatical settlement as taxable income. Under IRS code 101(g)(2), such payments are treated akin to death benefit payouts, which are generally not taxable.
A similar transaction, known as a “life settlement,” occurs when a policy owner is not terminally ill. In these cases, the IRS does not view the proceeds as a death benefit payment. Consequently, a portion of the amount received may be taxable.