One of the great benefits of life insurance is that in most cases, it allows you to transfer a sizable amount of money to a beneficiary without tax consequences. There are, however, some circumstances that can subject some or all of a life insurance benefit to various types of taxes. Today, we’ll look at why some life insurance proceeds are taxed.
In some cases, rather than paying out the benefit immediately, a life insurance company holds it for a period or pays it out over time. During this time, the benefit can generate interest income, which is subject to income tax.
As people caught on to the value of tax-exempt life insurance benefits, some began making deals to generate tax-free windfalls. In response, Congress made the death benefit of any life insurance policy that is transferred for material consideration subject to the gift tax at the time it’s paid out. This most obviously applies to the sale of a life insurance policy but also to other situations in which the original policy owner realizes material gain as a result of transferring it.
What constitutes “material consideration” can be murky, but the 2017 Tax Cuts and Jobs Act added some clarity to the question of when a transfer makes a life insurance benefit taxable. It declares that the transfer of a life insurance policy is a “reportable policy sale” when the new owner has no other substantial family, business, or financial relationship with the insured. If a life insurance benefit becomes taxable due to a transfer, only a portion of it will be subject to tax. This includes any benefit amount over the sum of consideration, additional premiums paid by the recipient, and certain other costs specified by the IRS.
If you name your estate as the beneficiary of your life insurance policy, then the proceeds are included in the estate’s total taxable value, potentially making it subject to estate or inheritance taxes. Federal estate taxes apply only to estates valued at $11.58 million or more in 2020, but a handful of states apply their own estate and/or inheritance taxes on smaller amounts. Talk to a tax professional in your state to determine whether and how your estate would likely be taxed.
If you have trouble keeping up with premium payments on a whole life policy, surrendering it and taking any cash value that’s left after surrender fees could be an attractive option. Be aware, however, that any cash value you receive that exceeds your policy basis (the amount of premiums you’ve paid minus dividends you’ve received) is taxable as income.
Rather than surrendering your policy outright, you might take out a loan to help you make premium payments while you experience a dip in cash flow. This can be an effective strategy since loans against life insurance policies are generally not taxable as long as the policy is active and the loan doesn’t exceed the policy’s cash value. If, however, interest and fees build up over time, and the total loan amount eventually exceeds the cash value, then you’ll have to either repay the loan or surrender the policy.
Single-premium life insurance policies are classified as modified endowment contracts (MECs), making loans against them subject to federal taxes.
We’ve discussed general rules regarding the taxability of life insurance policies. To gain a full understanding of how taxes can affect the death benefit of your specific policy, speak with a qualified tax professional. For more information about life insurance, subscribe to the ELCO Mutual blog.