Are there Taxes on Life Insurance?

Life Insurance TaxesLife insurance is put in place to relieve the stress of your loved one’s after you pass away. This provides income security for families who depend on the insured’s income to live or if the insured is the breadwinner it will provide death benefits for the family so they can live without the breadwinner. You probably stumbled across this article because you’re curious about taxes on life insurance. You have come to the right place because in this article we will be talking about taxes on life insurance and some other important things to keep in mind.

The following are some quick points that you can read more about in this article;

  1. If you have estates that are worth over $5.45 million then you will be taxed very harshly upon your death.
  2. If you sold your policy to someone else in a life insurance settlement then the sale is taxable.
  3. For those of you that will owe taxes because of your estates are worth over $5.45 million, and want to avoid taxation, you will need to transfer ownership of your policy to another person.
  4. If the adult doesn’t have the money in hand for the premiums, you can gift the person up to $13,000 so that they can pay the premiums.
  5. Another way to remove the estate tax is to create an irrevocable life insurance trust.
  6. An irrevocable trust can not be modified or terminated without the permission of the beneficiary.
  7. The IRS created a regulation in which oversees proper ownership and is known in the financial world as the three-year rule.
  8. The three-year rule states that any gifts of life insurance policies made within three years of death are subject to federal estate tax.
  9. Even if an estate is large enough to be taxed, it will not be taxed if the payouts are to a spouse.
  10. If you decide you no longer want your permanent life insurance policy, you can surrender it and receive a lump sum. As long as your surrender payout is less than what you paid in then you will not have to owe taxes.
  11. Good news for somebody that just inherited or will inherit death benefits is that it isn’t considered as a form of gross income.
  12. If a church or charity is the beneficiary of a life insurance policy, they are still tax exempt.
  13. There are two approaches for assigning more than 2 beneficiaries; Per Stirpes, and Per Capita.

Life insurance is taxable in these cases:

  1. If you have estates that are worth over $5.45 million then you will be taxed very harshly upon your death.
  2. If you have unpaid loans against your policy you will be subject to tax on the loan balance.
  3. If you have surrendered a life insurance policy then it built up more value than you paid in and you owe income taxes on the amount of the payout.
  4. If you sold your policy to someone else in a life insurance settlement then the sale is taxable.

How to avoid the Estate Tax?

For those of you that will owe taxes because of your estates are worth over $5.45 million, and want to avoid taxation, you will need to transfer ownership of your policy to another person. If you decide to transfer ownership you should choose a competent adult to be the new owner, then you will have to call the insurance company to follow the proper procedures and fill out the proper documentation. Then the new owners will have to pay the premiums on the policy. If the adult doesn’t have the money in hand for the premiums, you can gift the person up to $13,000 so that they can pay the premiums. This means that you will be giving up all rights to make any changes to this policy in the future. The last thing you will be receiving is a written confirmation from your insurance company as proof of the ownership change.

Another way to remove the estate tax is to create an irrevocable life insurance trust. An irrevocable trust can not be modified or terminated without the permission of the beneficiary. This allows the one who is granted transferred assets into the trust and will remove all his rights of ownership to the assets and the trust. The grantor will be relieved of tax liability on the income generated by the assets. The difference of transferring ownership and creating an irrevocable life insurance trust is that you can control who handles the money in the trust document versus just giving away ownership, this will not allow you to control any of the money.

The downfall of transferring ownership & irrevocable trust

The IRS created a regulation in which oversees proper ownership and is known in the financial world as the three-year rule. The three-year rule states that any gifts of life insurance policies made within three years of death are subject to federal estate tax. For example if you want to give all your benefits to a young minor, you appointed a responsible adult to be your trustee until the child becomes of age, and you made these arrangements a year ago and you are expected to pass in 3 weeks, the money and estates will be subject to be taxed since the insured’s death violated the three-year rule.

Life insurance isn’t taxable in these cases:

  1. Even if an estate is large enough to be taxed, it will not be taxed if the payouts are to a spouse.
  2. Beneficiaries will not have to pay taxes on what they receive as death benefits. However, if you transfer a policy for value during your lifetime the proceeds received by your beneficiary are taxable.
  3. Because Permanent life insurance policies provide an option for the accumulation of cash value gains, these cash value gains are not subject to income tax.
  4. If you decide you no longer want your permanent life insurance policy, you can surrender it and receive a lump sum. As long as your surrender payout is less than what you paid in then you will not have to owe taxes.
  5. When Mutual insurance companies give money back to their policyholders yearly in the form of dividends, they are not taxable.

Life Insurance Inheritance Taxes

Good news for somebody that just inherited or will inherit death benefits is that it isn’t considered as a form of gross income. Since this isn’t a form of gross income then you do not have to report this to the IRS. Unless you have received interest from your life insurance policy, the money that is added to the principal cash value of the life insurance policy will be taxable.

Some facts about life insurance tax

  • In 2015, $1.6 trillion in revenues were collected by the federal government and 47% were individual income taxes. 33% of the revenues were social insurance taxes and 11% were corporate income taxes.
  • IRC section 79 provides an exclusion for the first $50,000 of group-term life insurance coverage provided by employers have no tax consequences.
  • If a church or charity is the beneficiary of a life insurance policy, they are still tax exempt.

Choosing a Life Insurance Beneficiary

When choosing a life insurance beneficiary you should consider:

  • Family: If you have one or two family members who are dependent on you for both your financial support and income then you should list them as your beneficiaries. Your contingent family beneficiaries can include; your spouse, or domestic partner, children, sisters and brother or parents.
  • Legal Guardian: If you choose a minor as your beneficiary then the life insurance company may require that you name a legal guardian as the beneficiary. Using the Uniform Transfers of Minors Act will allow you to use the minor instead of using a legal guardian.
  • Estate: If you choose your estate to be your beneficiary then the proceeds will go to the Executor or Administrator of the estate. This will have to be approved or designated by the probate court. You may not use a specific name of a person on the beneficiary designation of your policy.
  • Charity: You can name a charity as either your primary or contingent beneficiary.
  • Trusts: You can choose to set up a trust which you can designate one or more trustees and name the trust beneficiaries.

What is a Primary beneficiary?

The primary beneficiary is the person who will be receiving the proceeds of the life insurance when the insured person dies.

What is a Contingent beneficiary?

A contingent beneficiary is someone who will be the second beneficiary, The contingent beneficiary will not receive any of the life insurance proceeds if the primary beneficiary is still alive when the insured person dies. The contingent beneficiary will only receive proceeds only if the primary beneficiary dies before the named insured.

What if I want more than one beneficiaries?

There are two approaches that you can take if you want more than one or two beneficiaries. The first approach is the Per stirpes, which can designate your beneficiaries by “branches of the family”.This simply means that with this approach, your death benefits will be passed down or divided equally among the beneficiaries. For example if you have two children (Mary, and Sam) designated as your beneficiaries and one dies (Sam) before you die and then shortly you die as well, then 50% of your benefits will be given to the surviving child (Mary) and the remaining 50% will be equally passed down to that child’s (Mary) surviving future or current children.

The second approach is the Per capita approach. The Per capita approach simply means that the proceeds are divided equally among all the beneficiary survivors of the lineage line. For example using the scenario above let’s say that Mary didn’t have any children to pass down that 50% to, but Sam had five children, then that 50% would be divided into fifths so that Sam’s five children receive one-fifth of the life insurance proceeds.

Final Thoughts

In conclusion when in doubt, consult a professional. Tax rules are always changing and it is important to always be on the most updated page of these rules. If you have any questions on taxes of life insurance policies please feel free to contact InsureChance, we are here to help! If you have questions about beneficiaries or want to move around your policy give us a call, we strive to help our clients: 888-492-1967 or simply hit the chat button below. Welcome to InsureChance!

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About Mack Dudayev

Mack is owner and life insurance expert at InsureChance. On a mission to create a way everyone can understand, afford and attain the right life insurance coverage to protect their financial responsibilities.

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