Life insurance is designed to pay out a death benefit to your beneficiaries, if you die while the policy is in effect, usually in a lump sum. Fox 6’s recent article entitled “Is life insurance taxable?” explains that when large amounts of money change hands, taxes are usually a given. However, that’s not the case with most life insurance.
There are some special situations that may involve taxes, like inheriting a large estate or electing to receive policy benefits in installments. However, there are strategies you can leverage to avoid paying taxes on life insurance.
Beneficiaries don’t usually have to pay taxes on money received from a life insurance policy because the IRS doesn’t consider life insurance proceeds as taxable income. If you have an accelerated death benefit rider and need to access your own policy’s proceeds due to a terminal illness, that also won’t be taxed.
While you most likely won’t have to worry about taxes on a life insurance payout, there a couple of exceptions:
- If all the policyholder’s assets meet the IRS’ federal estate tax threshold ($11.7 million in 2021), the policy’s proceeds could be taxable
- If you elect to get the policy benefits in incremental installments instead of a one-time life insurance payout, you’ll have to pay taxes on any interest that accrues
- If a person takes out a life insurance policy on someone other than himself – or herself, then policy’s benefits are considered a gift, and any monetary gifts above $15,000 are taxable; and
- If the policyholder dies with an outstanding cash value loan, the policy’s death benefit could be used to settle it. Any amount the policyholder borrows beyond what they’ve paid into the policy is taxable.
These situations usually concern beneficiaries, but there are a few situations that could leave the policyholder responsible for taxes. In addition to taking out a policy loan, when you sell or surrender your policy and the cash value exceeds the amount you’ve contributed through premiums, the excess is taxable.
There are strategies for getting around this situation:
- To avoid taxes, you can work with your life insurance company to legally transfer the policy to a new owner, such as the beneficiary so the policy’s proceeds aren’t included in the estate. However, this will place the responsibility for making premium payments and the ability to change the policy in the new owner’s hands.
- An irrevocable life insurance trust or ILIT irreversibly transfers ownership of the policy to the trust, removing it from the taxable estate.
- Installment payouts accrue interest and may be taxed, but a lump sum payment isn’t.
Talk to an experienced estate planning or elder law attorney about life insurance and how it can fit into your estate planning strategy.
One of the main goals of our law practice is to help families like your plan for safe, problem free, and successful transfer of assets to the next generation. Call our office today to schedule a time for us to review your estate plan and identify the best strategies for you and your family to ensure your legacy of love and financial security. Our office is located in Santa Ana, CA but we serve all of California including Irvine, Orange, Tustin, Newport Beach, and Anaheim.
Reference: Fox 6 (April 14, 2021) “Is life insurance taxable?”