What To Know About Taxes On Life Insurance

They say that the only guarantees are death and taxes, but the last thing you want to think about when it comes to life insurance is what you owe the Internal Revenue Service. 

Yet, to avoid adding financial troubles on top of emotional ones, there are certain steps you can take to reduce your tax liability. If you're creating your own life insurance policy, it's smart to follow the tips from the experts to ensure that your beneficiaries are provided with what you expect for them once you pass. Let's take a closer look at what to know about taxes on life insurance.

How Life Insurance Works

Life insurance policies are a common way that people (especially as they age) create a plan to support their loved ones financially. Policyholders pay the premiums on the policy, often on a monthly basis, and then the named beneficiary will receive a lump sum upon death, also known as the death benefit. 

There are two main types of life insurance: permanent life insurance and term life insurance. The former can gain cash value over time, but it is not taxable. If the policy pays dividends on an annual or quarterly basis, that cash is also not taxable – unless your investments exceed what was paid in premiums.

If the life insurance proceeds come when the insured person is terminally ill, the proceeds are known as "terminal illness riders." They are also excluded from your gross income.

Benefits, in General, Are Tax-Free

According to the IRS, life insurance proceeds that you receive as a beneficiary when a loved one dies are not included in your gross income. This means that you will not have to report them to the government or pay taxes on them. Policies that are left to spouses, for example, are not counted as part of the deceased's estate.

However, any interest that is received as part of this income is taxable. This happens when a policyholder decides not to pay out the policy immediately upon death. If they instead wait for a certain period of time, any interest that results will be taxable income.

Another situation in which a life insurance policy could be taxable is if the person makes the beneficiary of the life insurance policy the estate, rather than an individual. The person who inherits the estate will then be liable to pay taxes for the estate tax. This can also happen if the named beneficiary of the estate dies in advance of the policyholder. It is important to name a primary beneficiary as well as a contingent person to the policy to avoid this scenario.

In 2017, the Tax Cuts and Jobs Act of 2017 made the estate tax exemption $11.4 million in 2019. This is good news for beneficiaries unless the estate is worth more than that. Anything over $11.4 million will be taxed at 40 percent.

Still, many estates – when you add up life insurance policies, homes, and other investments – will owe taxes. One way to ensure that proceeds from a life insurance policy are not included in this taxable estate is to transfer ownership of the policy in advance of the insured person's death. 

Transferring to Reduce Tax Burden

There are a few steps to do this. First, contact your insurance company and fill out the transfer of ownership forms. You'll need to name a competent adult as the new owner, but it can still be the policy beneficiary. Next, that person will have to pay the premiums on the life insurance policy to prove their ownership. Keep in mind, you are able to gift up to $15,000 per person in 2019. That money can go toward paying the premiums.

Once you transfer ownership, you give up some rights. You'll no longer be able to make changes to the policy in the future unless they are approved by the new owner. This can be especially challenging in divorce proceedings, so consider your new owner carefully. Once you've chosen the new owner be sure to get it in writing from your insurance company.

Create a Life Insurance Trust

Another way to exclude your life insurance policy from your estate is to create an irrevocable life insurance trust (ILIT). Like transferring ownership, you won't be able to keep any rights to revoke the trust and you will no longer be considered the owner. 

This is a good plan if you are concerned that the newly named owner won't dutifully pay the premiums or if the beneficiaries are children who are minors from a previous marriage. You'll be able to name another family member as the trustee for the children through the trust. 

Give Gifts Now, Not Later

Keep in mind that you should transfer ownership and gifts sooner rather than later. The IRS has a rule known as the "three-year rule," which states that transfers within three years of death can still be subject to federal estate tax.

You'll also want to check to see if there is what is known as an "apportionment clause" in the will. This transfers the responsibilities for taxes of the estate to the beneficiary. This is considered estate tax, not income tax – but it's due to the IRS nonetheless. 

It's also important to be careful if, before you die, you plan to take out cash from the policy that goes beyond the premiums you've paid. Whether the money goes to you or to someone else, it is considered taxable income. You'll need to report it on an IRS Form 1099-INT or a 1099-R.

If you decide to end the policy before your death, the difference in the value of the policy and what you've paid in premiums will also be taxable.

Once you understand these stipulations and restrictions on life insurance, you can make a good decision to benefit your loved ones long after you have passed away. If you're someone who has recently benefited from a life insurance policy death benefit, experts recommend not making quick decisions. The best financial plans are ones that happen away from emotional situations and with time to make the smartest actions for your loved one's lasting legacy.

Still have questions? PolicyScout is here to cut through the confusion. Learn more about life insurance in our learning section or get a quick, easy and free life insurance quote today.