What Is the Tax Treatment for a Life Insurance Benefit?
Funds From Interests
The majority of the time, income received in the form of interest must be taxed. There is no exemption with Life Insurance. This means that the recipient will only have to pay taxes on the interest earned on the life insurance earnings rather than the full benefit if the beneficiary chooses to collect the funds at some point in the future rather than immediately upon the policyholder’s death.
The beneficiary will be responsible for paying taxes on the $50,000 growth if the death benefit is $500,000 and it earns 10% interest for one year before being paid out.
The Internal Revenue Service states that if you acquired a life insurance policy in exchange for cash or other assets, the total of the consideration you paid, any additional premiums you paid, and certain other amounts cannot exceed the amount that you exclude as gross income when filing taxes.
Taxes on Estates and Heirs
When naming a beneficiary for a contract like an IRA, an annuity, or a life insurance policy, investors often make the unwise choice of writing “payable to my estate” as the beneficiary.
When a financial product is designated to a person’s estate rather than a living individual, the product is subject to the probate process. Adding assets to an estate’s valuation can result in exorbitant estate taxes for a person’s heirs.
The value of your life insurance proceeds used to insure your life is considered part of your gross estate if the proceeds are payable:
Indirectly or directly to your estate
If you had any “incidents of ownership” in the insurance when you passed away, the proceeds would go to the people you designated as beneficiaries.
Do Life Insurance Beneficiaries Have to Pay Taxes?
Strategies for Deferring Taxes on Life Insurance Death Benefits by Changing Who Owns the Policy
Many estates will be exempt from federal inheritance tax. In 2022, the baseline exclusion amount for a decedent’s estate is $12.06 million, and in 2023, it rises to $12.92 million. There is a 40% ceiling on the highest tax bracket.
The increased federal estate tax exception and other provisions of the Tax Cuts and Jobs Act are currently scheduled to expire at the end of 2025 unless they are extended by Congress.
Life insurance payouts may or may not be included in a tax-due estate, depending on who owned the policy when the insured passed away. To prevent the federal government from taxing your life insurance payout, you must change the policy’s ownership to someone else.
In the event that you are contemplating a change of ownership, please keep the following in mind:
Select a responsible adult or legal entity to take over ownership (this person or entity may be the policy beneficiary), then contact your insurance provider to request assignment, or transfer of ownership, paperwork.
The policy’s premiums are the responsibility of the new owners. However, in 2022 you can give up to $16,000 per person and in 2023 you can give up to $17,000 per person, so the recipient might utilize portion of this present to cover premium costs.
You are waiving the right to modify this policy at a later date. If a friend, relative, or child is designated as the new owner, however, they will be able to make alterations at your direction.
Keep in mind that naming a new owner is an irreversible occurrence in the event of a divorce.
Get the insurance company to verify the ownership change in writing.
Paying Taxes on Presents
Since the insured and the policy owner are usually the same person, gift tax may be an issue if there are three people mentioned on the policy: the insured, the policy owner, and the beneficiary. However, if the insured and policyholder are two separate people, the IRS may consider the death benefit payment to be a gift from the policyholder to the beneficiary and thereby subject the payment to gift tax.
Gift tax is owed once you pass away, but your beneficiary won’t have to pay anything until the value of your estate is more than $12.92 million (in 2023) and your annual contributions total more than $17,000.
If the policyholder dies within three years of transferring ownership, the entire sum of the proceeds will be considered part of the policyholder’s estate.
Tax Avoidance Using Life Insurance Trusts
Establishing an irrevocable life insurance trust (ILIT) is another option for shielding life insurance payments from your taxable estate. For a change of ownership to go through, you can’t be the trust’s trustee or hold on to the ability to revoke the trust. When a policy is placed in trust, you are no longer legally responsible for its upkeep. As a result, the money won’t be counted for determining your estate.
What are the advantages of having a trust own something rather than just giving it to someone else? You may want to keep some legal sway over the policy for several reasons. Another reason to set up a trust is if you’re concerned that an individual owner won’t pay their premiums on time. If you have young children from a previous marriage who would benefit from the ILIT, you can choose a trusted family member as trustee and provide them access to the funds in accordance with the trust’s rules.
Possession Requirements for Life Insurance Policies
The Internal Revenue Service has established guidelines to help identify the beneficiary of a life insurance policy upon the insured’s demise. Gifts of life insurance policies made within three years after death are still subject to federal estate tax, therefore this provision is the major financial regulator regulating correct ownership. This is true for both the creation of an ILIT and the transfer of ownership to another person.
The person transferring the policy will also be investigated for any events of ownership by the IRS. The original policyholder loses the ability to make changes to the policy’s beneficiaries, borrow against it, surrender it, cancel it, or choose the policy’s payment alternatives after a transfer.
In addition, the policy might continue to be in effect without the original owner making any further premium payments. All of these things are part of having ownership of the assets, and if they are done, the tax benefit of the transfer could be lost.
Even if a policy transfer satisfies all the criteria, some of the assets involved may still be taxable. Gift taxes will be calculated and due at the time of the death of the original policyholder if the cash value of the policy exceeds the gift tax exclusion of $16,000 in 2022 or $17,000 in 2023.
Do Beneficiaries Have to Pay Taxes on Their Distributions?
Money from a life insurance policy is often exempt from taxation if you are the beneficiary.
Do You Have to Pay Taxes on Life Insurance Proceeds Left to You?
No. Unless the life insurance benefit earned interest, you do not have to report an inheritance from a life insurance policy as taxable income. In that case, the interest income might be subject to taxation.
How Can I Prevent Paying Taxes on Life Insurance Money?
The death benefit from a life insurance policy is often exempt from both federal and state estate taxes.
By making sure the necessary documentation and reporting requirements are satisfied in a timely way, taxes associated with interest generated during the collection process can be reduced.
Should I Tell the IRS About My Inheritance?
The IRS does not typically require notification of most inheritances. However, any profits made from the inheritance may be subject to taxation.
It is normal for people to have life insurance policies with death benefits ranging from half a million dollars to several million dollars. Your estate’s size may surprise you if you factor in the worth of your home, your retirement accounts, your savings, and everything else you own. Some people could have an estate tax problem if they lived long enough for their wealth to accumulate.
Maximizing your gifting potential and making ownership transfers of policies wherever possible at little or no gift-tax expense will help. Your estate may be able to save a lot of money in taxes if you survive at least three years after the transfer.