Are Life Insurance Benefits Taxable or Tax-Free?

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There are seven cases when life insurance benefits can be taxed, but a workaround may be possible for at least one case.

It’s not a fun topic, but you need life insurance if anyone depends on you being around.

Entire volumes can and have been written about what type of life insurance is best in which case and how to figure out how much insurance you should buy depending on your circumstances.

That’s all beyond our scope here.

We’ll dig into one, and only one, aspect of life insurance – taxability of benefits.

Are Life Insurance Benefits Taxable?

Generally, if you die when insured, your beneficiaries’ benefits shouldn’t be taxable as income. Also, any accelerated death benefits you may get if you’re diagnosed with a terminal illness or have some specific medical conditions should also generally be tax-free.

That’s the good news.

The less-than-stellar news is that there are at least 7 cases when some form of tax can result from life insurance policies.

Have a question to ask a financial advisor? Submit your question and it may be answered by a Wealthtender community financial advisor in an upcoming article.

7 Cases When Life Insurance May Be Taxable

First, even if the death benefit doesn’t count as taxable income, it may be included in your estate if you own the policy when you pass away. Most Americans aren’t subject to estate taxes due to the exemptions and/or thresholds at which they start applying.

However, if your estate is large enough, the death benefit may boost your estate beyond the relevant exemptions and thresholds and make at least part of the benefit effectively taxable. Note that if your surviving spouse is the beneficiary, no estate taxes would be owed because of the “unlimited marital deduction.” If your spouse then spends enough that the remaining estate at his or her passing falls below the relevant exemptions and thresholds, no estate taxes would apply. Otherwise, some or all of the death benefit may again result in estate taxes.

Second, if you take a loan against the cash value of your so-called permanent life insurance policy, in some circumstances, you may owe taxes. Specifically, if the loan amount is higher than the premiums you paid, and the policy lapses, or you surrender it before paying back the loan, the amount by which the loan exceeded the premiums paid may be taxable as regular income.

Third, if you sell your life insurance policy to a third party (a complicated process known as a “viatical settlement”), this may involve taxable income.

Fourth, if your policy accumulates interest or investment gains over time (more common with cash-value policies, such as whole life or universal life insurance), the interest portion of the death benefit may be taxable.

Fifth, certain factors (e.g., excessive premium payments) may cause your policy to be classified as a “Modified Endowment Contract” or MEC. Withdrawals and/or loans from MECs are generally taxable, and death benefits from MECs may also be taxable.

Sixth, if your employer offers a group life insurance policy (where you don’t pay the premiums) and the benefit amount is higher than $50k, the imputed cost of the portion of coverage that’s over $50k is subject to payroll taxes.

Finally, if your beneficiaries receive the death benefit as an annuity rather than a lump sum, any interest accrued by the annuity may be taxable.

You can read more details in this informative IRS FAQ.

A Possible Workaround to the Estate Tax Case

If you anticipate your estate may be large enough to be partially taxable, you could set things up where your beneficiaries own your life insurance policy, in which case the death benefit shouldn’t be lumped into your taxable estate.

While transferring policy ownership may be an important estate-planning tool, there are some tricky considerations. For example, you need to survive at least 3 years after the transfer, or the death benefit may revert to your estate. Also, the so-called “interpolated terminal reserve value” of the policy (what it would cost to buy such a policy at the time you transfer ownership) is considered a gift. If the value of that gift is too high, it may be subject to gift tax and/or reduce your lifetime estate-tax exemption.

Another important thing to consider is that if you transfer ownership of the policy, the new owner can do whatever s/he wants with it, including changing beneficiaries, borrowing against it, selling it, surrendering it, or canceling it. Thus, you should carefully consider if you trust that the proposed new policy owner is stable, competent, savvy, and aligned with your desires regarding the policy.

Caveats

Two important caveats to keep in mind are that (a) (non-federal) tax laws and regulations vary from one jurisdiction to another, and (b) different rules may apply to term vs. permanent life insurance policies.

The Bottom Line

Life insurance death benefits are typically not taxable to the beneficiary. However, the above shows multiple cases where some form of tax could arise from how you set up your policy, the size of your estate, what you do with your policy, and/or how the beneficiaries receive the death benefit.

Since life insurance, estate planning, viatical settlements, compensation models, etc. are all complicated topics, setting them up and making changes are best done in consultation with professionals who are intimately familiar with your individual situation and all the applicable laws and regulations.

You wouldn’t want to set things up wrong and have a large chunk of the money you planned to help your loved ones end up in Uncle Sam’s hands, right?

Kevin M. Arquette, CFP®, Wealth Manager, Managing Partner, Wealthpoint Financial Planning says, “When considering life insurance, remember the primary purpose of a policy is to provide a death benefit. While potential tax advantages shouldn’t be overlooked, how the intended beneficiary receives the funds plays a significant role in designing an effective insurance plan. That’s why it’s essential to collaborate with a qualified advisor or tax professional who can help create a comprehensive roadmap to achieve your goals.”

Disclaimer: This article is intended for informational purposes only and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

About the Author

Opher Ganel

My career has had many unpredictable twists and turns. An MSc in theoretical physics, a PhD in experimental high-energy physics, a postdoc in particle detector R&D, a research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started several other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. I draw on these diverse experiences to write about personal and small-business finance to help people achieve their personal and business finance goals.

Follow me on Medium (opher-ganel.medium.com).

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This article originally appeared on Wealthtender. To make Wealthtender free for our readers, we earn money from advertisers, including financial professionals and firms that pay to be featured. This creates a natural conflict of interest when we favor their promotion over others. Wealthtender is not a client of these financial services providers.