One of the most common questions we get asked at IntelliQuote is, “Are taxes paid on life insurance payouts?” One of the primary benefits of a life insurance policy is that life insurance proceeds aren't taxable - most of the time. In nearly all cases, you can purchase a life insurance policy and feel secure in knowing that your beneficiary won't have to pay taxes on the eventual payout. However, there are a few instances where a life insurance policy can serve as a tax shelter and some cases where you may be subject to a life insurance pay out tax. Read on to learn how you can protect your loved one and potentially some tax payments.
Understanding The Possible Life Insurance Pay Out Taxes
So, is life insurance taxed? The simple answer is, it depends. There are three main taxes that your life insurance policy may be subject to and all have different rules for when, how, and why your policy may be taxed. The taxes your beneficiary may become liable for are:
- Estate Taxes
- Federal Taxes
- States Taxes
However, tax payments on life insurance death benefits are not common!
Who is Your Life Insurance Policy Beneficiary?
Many people worry about whether their heirs will have to pay taxes on life insurance policy proceeds, this is a common concern. Yet, if your policy beneficiary is your spouse, you have nothing to worry about. Spouses are able to transfer wealth to each other free of taxes. This is thanks to Marital Deduction benefits offered by the Unified Gift And Estate Tax. The marital deduction allows a person’s estate to be passed to their spouse untaxed, as long as the spouse is a US citizen. If the spouse is not a US citizen the estate will be taxed based on the Personal Estate Tax Exemption rules. So, if you've named a non-citizen spouse, your children or anyone else as beneficiaries on your life insurance policy, taxes may be an issue under certain conditions.
When Your Beneficiaries May Be Taxed
Federal Estate Tax
According to IRS Reports, approximately 2 percent of U.S. deaths are subject to an estate tax. Why? Because the value of their estate exceeded the $5.6 million tax threshold. However, the recently passed Tax Cuts and Jobs Act has doubled this tax-free amount to $11.2 million per person. This means that married couples can leave an estate worth $22.4 million without their heirs needing to pay a life insurance pay out tax. If the value of your policy and other transferred assets exceeds the federal estate tax exemption, then the policy would be taxed. Even in these cases, life insurance policy proceeds are often used to pay those estate taxes, which can reach in the hundreds of thousands of dollars.
State Estate Tax
Another way your beneficiaries could be taxed is through state estate taxes. There are a number of states that impose estate taxes, however many of these follow the same threshold amounts as the Federal government. There are a few exceptions, such as Vermont, where estates are taxed with a value of $2.75 million or more. Check your state’s estate thresholds to confirm whether your estate will be subject to a state tax.
Annual Tax Returns
There are a few instances where life insurance proceeds could be subject to taxes, aside from the estate tax scenario already mentioned. Let's assume that you have a permanent life insurance policy and have taken out a tax-free loan from your built up cash value. If you decide to cancel that policy without repaying the loan, you'll likely owe some taxes. Also, if you sell or cancel your policy and the surrendered value is greater than what you paid in, due to investment returns, you might have a tax bill. If your beneficiaries elect to receive their payout over time with interest instead of as a lump sum, the interest paid by the insurance company will be subject to taxes.
If you own a business and have considered taking out key man insurance or any other form of employer-owned life insurance, it's also likely that the benefits from those policies will be taxed. A Congressional rule was put in place that applies to policies issued after August 17th, 2006. This new rule requires certain notices and consents to be signed before a life insurance policy is issued. Otherwise, the proceeds paid on the life insurance policy will be taxed.
Using Your Life Insurance As A Tax Haven
Are You Maxed Out on Retirement Savings? If you have maxed out your IRA and 401k contributions for the year, you might have a tax concern. Finding additional investments for retirement that can produce income and provide tax advantages can be a challenge. One solution is the Indexed Universal Life (UIL) insurance policy that offers tax benefits.
The cash value on the UIL policy achieves investment returns that are tied to the market, with minimum return guarantees. Also, you are able to take tax-free distributions of accumulated cash value, can exchange your policy without triggering taxes, and the death benefit almost always passes on to loved ones tax-free.
Protect Your Loved Ones With A Life Insurance Policy
Not only is a life insurance policy important to safeguard your family's financial future, but its tax benefits make it an attractive investment. In most cases, life insurance payouts, dividends, and cash value accumulation are not subject to income taxes.
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