Pop quiz: Do you pay taxes on life insurance?
When we talk about life insurance, we usually think in terms of income. If you pass away, loved ones who rely on you financially can use the death benefit to pay for your funeral costs, their own living expenses and more. Basically, a life insurance payout can help sub in for the money you would have provided. (Here’s more on how life insurance works.)
That said, life insurance proceeds aren’t considered the same as income in the eyes of the IRS. Taxes apply differently to life insurance.
Here’s what you need to know.
A refresher course: When you get a life insurance policy, you have the chance to name your life insurance beneficiary or beneficiaries. That’s the person or people who would receive the lump sum benefit from the insurance company if you were to pass away.
Generally, there’s no income tax on life insurance proceeds that go to a beneficiary after the insured person dies.
To understand why that’s the case, we need to explore a concept called “human life value” or HLV. “It is hard to put a price on someone’s life,” says Marguerita Cheng, a Certified Financial Planner and CEO at Blue Ocean Global Wealth. “This is the economic value or financial shortfall that [your] premature death would bring.”
Because your life has value beyond simple income—and because you would have contributed more value over time had you continued to live—the IRS doesn’t see life insurance proceeds as income. It doesn’t matter if your life insurance policy matches your anticipated income dollar for dollar (which is unlikely anyway, because your policy doesn’t take inflation, raises or potential job changes into account).
Think of this in terms of other kinds of insurance: If someone hits your car and the auto insurance company sends you a check for damages, you don’t get taxed on that money. It’s not income, it’s a benefit you paid the insurance company to be eligible for. Life insurance is similar.
The bottom line is that life insurance benefits are usually tax free. That’s a big relief for many beneficiaries.
That said, there are several situations when some of the proceeds from a life insurance policy could be taxable.
The death benefit on your life insurance policy isn’t taxable. Sometimes, though, that’s not the only money you’d collect from a life insurance payout. Term life and whole life policies can both come with taxable “extras.”
Generally, life insurance proceeds come as a lump sum. That said, it can be overwhelming to receive 10 years’ worth of income (or more) in one fell swoop, especially on the heels of a significant personal loss.
When you set up a life insurance policy and choose your beneficiary, you can often specify whether you want the insurer to pay the death benefit as a lump sum or in installments. If the death benefit is set up to pay in installments, you’ll earn interest on the remaining funds the life insurance company is still holding. That interest is taxable.
To be clear, a lump sum sitting in your savings account earns interest, too. So, in that sense, life insurance benefits aren’t such a special situation; your bank will send you a form each year to report your interest to the IRS. Cheng notes that, for people who choose the installment option, insurance companies tend to keep proceeds in higher-yield accounts than many bank accounts. That means you might earn a little more interest (and therefore pay a little more tax).
Interest probably isn’t going to add a very substantial amount to the life insurance payout, but it’s helpful to know that when an insurance company sends checks for death benefit installments, a little piece of that money is going to be taxable interest.
(One exception? Interest from a life insurance policy through the U.S. Department of Veterans Affairs isn’t taxable or reportable, according to the IRS.)
Permanent life insurance policies, such as whole life insurance, have a “cash value” component that grows alongside your premium payments. The idea here is that not all the money is tied up in the death benefit; you can borrow against or withdraw from this cash value while you’re still alive.
Over time, this cash value gradually makes up more and more of the policy’s death benefit (because you grow it over the years), until you’ve funded the entire total of your death benefit.
During this time, the insurance provider invests your cash value so it earns value, either based off market changes or the insurer’s guaranteed minimum rate, but you do not pay capital gains tax. This interest is tax-deferred.
If you receive distributions or cash early (in other words, borrowing from the policy while you’re still alive), you pay taxes on the amount of money beyond what you’ve paid into the policy. So if you contributed $100,000 through your monthly payments and the cash value is worth $110,000 due to interest and other gains (these figures are arbitrary and don’t correspond to any actual policy), then you’d pay taxes on the extra $10,000.
Some whole life policies also pay policyholders dividends. Dividends count as a return of your premium payment, so generally you don’t pay taxes on them. The only case where you would pay taxes on the dividends is if they exceed what you paid into the policy that year. So if you paid $1,500 into your policy and received $2,000 in dividends, you’d pay taxes on the $500 over what you paid.
All of that discussion relates to the cash value that you can use when you’re alive. But when your beneficiary receives money as a death benefit after your passing, they will not need to pay taxes, even if the amount they receive is higher than the total premiums you paid into the policy.
That’s because you’re paying for the insurer to guarantee a certain face value on your life insurance policy, even if you get hit by a car in the first year. Generally speaking, the amount the beneficiary receives stays the same throughout the duration of the policy. And, as with term life insurance benefits, this payout is not taxable.
One other way that you could end up paying taxes on life insurance is if you fail the “seven-pay test” on a permanent life insurance policy.
Basically, permanent life insurance is attractive as a way of providing a tax-free chunk of money to your inheritors. (Because remember: They don’t have to pay taxes on the benefit they receive after you pass away.) Some people turn to life insurance not so much as a way of securing their family against unexpected loss of income, but as a way to shield wealth from creditors and avoid as many taxes as possible.
Congress felt that life insurance isn’t really meant to be used as a tax shelter, so they passed the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). TAMRA sets limits on how much you can pay in premiums over the first seven years of owning the policy (as long as you don’t change policy terms, which can restart the seven-year countdown).
This limit varies depending on your age and the face value of the policy, but the idea is that you need to maintain a certain difference between the death benefit and the cash value you’ve accumulated so far. That’s because accumulating a ton of cash value right away changes the nature of the thing from an insurance policy to a place where you can squirrel away a lot of cash.
“The IRS bases how much money you can put into a policy on actual data, because otherwise it’s considered an ‘MEC,’ and it’s no longer insurance. It’s for wealth accumulation,” says Cheng.
An MEC, or modified endowment contract, can still be a useful estate planning tool, but it has different tax requirements. With an MEC, you’ll withdraw the taxable portion first, rather than getting to withdraw the nontaxable portion of your cash value first. If you want your policy to remain classified as “true” life insurance, stick to your premium limits.
If you name a specific beneficiary on your life insurance policy, the funds go directly to that person when you die. Life insurance money generally isn’t part of your estate in the probate process and isn’t subject to estate taxes.
But let’s say that instead of writing a person’s name as the beneficiary of your policy, you left instructions to follow wishes you laid out in your will. Leaving a life insurance policy to your estate might be your preferred option if you have a complex plan for how to divide money when you’re gone.
As of 2019, individuals with a total taxable estate worth less than $11.4 million don’t need to file an estate tax report. Married couples can double that amount, to $22.8 million. So most American families don’t need to plan on paying estate taxes for life insurance proceeds or anything else.
If you think your estate will end up large enough to be subject to estate taxes, talk to an estate planning professional about options like a trust that could keep the life insurance death benefit separate from your estate.
If you’re unsure how taxes apply to your particular situation, it doesn’t hurt to run details by your tax advisor. In the vast majority of cases, though, Uncle Sam doesn’t have anything to say about money you receive from a life insurance policy payout.
This article is meant to provide general information and not to provide any specific legal advice or to serve as the basis for any decisions.
Fabric isn’t a law firm and we aren’t licensed to practice law or to provide any legal advice. If you do need legal advice for your specific situation, you should consult with a licensed attorney and/or tax professional.
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