Life Insurance, Taxes, and Death - Who Pays for What - Zupnick Associates

(by Jordan Johnson)

“Does life insurance get taxed?” That’s a common question for policyholders, especially since life insurance is essential to estate planning.

The answer is, sometimes. This article will explore the different roles of a typical policy and how certain individuals may face tax implications.

What Are the Three Roles in a Typical Life Insurance Policy?

To fully understand the tax consequences of a life insurance policy, it’s important to know the three primary roles that are tied along with any policy. These roles are the person insured, the policyholder, and the beneficiary.

The Insured

The insured is the person whose life is covered by the policy. When the insured dies, the life insurance proceeds are paid out, known as the death benefit.

The Policyholder

The policyholder, sometimes known as the policy owner, is the entity that owns the policy and thus pays for the premiums of the policy. The policyholder could be the insured, a family member, partner, trust, or other entity.

The role of policyholder also comes with other important and useful responsibilities, such as:

  • Naming the beneficiary.
  • The ability to transfer ownership.
  • The ability to manage cash funds in permanent life insurance policies.
  • Determining the length of coverage.
  • The ability to surrender or cancel the policy.

The Beneficiary

The beneficiary is the entity or entities that receive the death benefit when the insured dies. The way the beneficiaries are paid out is dictated by the current beneficiary designations laid out by the policyholder.

Is the Death Benefit Taxed?

The death benefit of a life insurance premium is usually completely income tax-free to the policy’s beneficiary; however, in some cases, the death benefit may be taxed before it ever reaches the beneficiary. 

Federal Estate Tax

As of 2022, most estates won’t be liable for the federal estate tax, as the threshold currently sits at $12.06m, although this is always subject to change. 

When calculating tax for a death benefit, if the policy is still owned by the insured at the time of death or up to three years before, the death benefit could count towards the estate’s total value for tax purposes.

Note: When considering spouse life insurance, the death benefit is typically exempt, even if exceeding the federal estate tax-free limit.

 

State Inheritance and Estate Tax

Some states also include a state estate tax and inheritance tax, which largely works in the same way, with some heirs liable to be hit by two taxes at once.

States with these tax systems in place often have a much lower tax exemption limit than their federal counterparts, with states like Oregan having an estate tax on everything above $1m. 

Trust Funds

For those who have estates that exceed the federal or state limits for tax purposes, an irrevocable life insurance trust (ILIT) might be an ideal solution, as it will act as a shelter from estate tax as long as the policyholder transfers it at least three years before the insured passes.

A trust is especially useful if the current policyholder is uncomfortable with the idea of transferring ownership directly to the beneficiary due to a poor relationship or perhaps poor financial planning that may lead to missed payments and a canceled or surrendered policy.

Taxable Interest

If the policyholder dictates that the death benefit should be kept with the insurer and given to the beneficiary in monthly installments, the lump sum left with the life insurance carrier often accrues interest.

Although the initial life insurance cash out is not included in gross taxable income for the beneficiary, any interest received is liable for taxation

Gift Tax 

If different entities fill the three roles of a life insurance policy, there could be a gift tax to pay. This is because the IRS considers the death benefit a gift from the policyholder to the beneficiary.

While the policyholder won’t typically pay any tax until they die, and unless their estate is worth over $12.06m (adjusted each year for inflation), it still makes sense to avoid this as the IRS requires you to report sizable gifts on your income tax returns. 

That means it could be best to leave out the headache and keep your policy to just two named entities.

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