They say that only two things in life are certain – death and taxes. Thankfully, when you’re applying for life insurance, you can be reasonably sure that you’ll get around any taxes on the policy’s payout.
Typically, life insurance payouts are not taxed. For most families looking to protect themselves with $500,000 in coverage, taxes on the payout of a policy should be the last thing on their mind. Unless your policy falls into a few very specific situations, your beneficiaries will receive the full payout as a lump sum without any deductions or charges (including taxes).
When Income Tax Affects a Life Insurance Payout
Life insurance proceeds are almost never taxed, but there are a few cases in which owners of permanent insurance policies will see Uncle Sam take a little bit of money off the top. These mostly have to do with surrendering the policy while the insured is still alive, the policy lapsing, or when the person being insured takes out a loan against the policy.
Delayed Payout Interest
Instead of taking the Death Benefit of a life insurance policy all at once as a lump sum, it’s also possible to receive the policy’s payout in regular installments. While the policy is being paid out, the carrier is making money for the beneficiary by holding on to the remainder – similarly to how a bank account gains interest.
The interest that the carrier earns with your payout will also be going to your beneficiaries as part of the regular payments, but the percentage of each payout check that comes from interest is subject to income tax. You’ll still be giving your beneficiaries extra money in the long run, just not quite the full interest amount.
Profit from Surrendering a Policy with Accumulated Interest
Permanent life insurance policies don’t work the same as term policies – they’re able to build cash value over time as the policy’s owner makes payments. If the policy has built up cash value greater than its accumulated premiums, and is then surrendered, any gains over and above the normal premium payments will be taxed as ordinary income.
Ownership and Beneficiary Mistakes
If a policy is owned by one person, covering a second person, and with the payout going to a third person, the death proceeds will be considered a gift to that beneficiary and may be subject to gift taxes.
For example, under the tax code, if a wife owns policy on her husband, but lists their children as the policy’s beneficiaries, then the death proceeds of the policy will treated as gift from the mother to the children when the father dies.
Modified Endowment Contracts
Beginning in the early 80s, certain types of life insurance policies called single-premium policies came into fashion after an overhaul of the tax code in 1986 eliminated many tax shelters that were in vogue at the time.
Basically, you paid a high premium up front in a lump sum and got a certain amount of guaranteed life insurance – it was kind of like a whole life policy that only had to be paid for once.
The issue was that you could also continue pumping money into these plans, which increased the duration and payout of the policy. You were also able to borrow money against the value of the policy as a loan. This allowed people to dump millions into life insurance policies that essentially acted like overblown, tax-free, private bank accounts.
In order to close the loophole that single-premium policies presented, congress passed legislation turning any policy that didn’t pass certain tests to be a “Modified Endowment Contract,” or MEC. This rule was called the 7-pay test
The 7-pay test basically places a cap on the amount of money you can put into a policy for the first seven years of its duration – pump in more money than the cap allows, and your policy becomes an MEC, which is subject to both normal income taxes and an additional tax penalty whenever loans are taken out on the policy before age 59 ½. However, the death benefit portion of the policy still isn’t taxed, even if it becomes an MEC.
How the Estate Tax Affects a Life Insurance Payout
Even though the payout of a life insurance policy won’t be hit with income tax, if the money gained from your policy pushes you over the estate tax threshold (which was placed at $5.49 million in 2017), any money in your estate above that threshold will get hit with the estate tax upon your death. In addition, your state may also have an estate tax in place which can add additional stipulations and costs to life insurance policies dedicated to your estate.
Basically, your life insurance payouts will be taxed unless your policy is set up so that both the beneficiary and owner of the policy aren’t a part of your estate.
An easy way to dodge the estate tax with regards to your policy is to transfer ownership of the policy to a family member you trust to dole out the life insurance proceeds. The downside is that you’ll give up all control over the policy to the new owner. If the new owner were inclined to go against your wishes, they could rearrange the payout’s distribution in a way that doesn’t match what you wanted, which can cause quite a bit of trouble after you’re gone.
Changing the ownership of a policy is simple – just a matter of sitting down with the person you’d like to own the policy and filling out a form. Life insurance carriers offer these forms as PDFs online, so you can download and print any paperwork you would need.
However, the IRS will look at your case a little more closely if you try to shift the ownership of a policy to someone else within three years of your death. According to the US tax code, any gift made by a person in contemplation of their own death is subject to at least one year of scrutiny – this law was put in place so that terminally ill billionaires couldn’t dodge the estate tax by giving their entire estate away when they’re informed that they’ve only got a short while left to live.
Life insurance is actually the only type of gift that is subject to a three-year look-back in an extension of that rule, which helps the IRS determine whether or not the ownership of a policy was changed solely because the person being insured believed they were going to die soon. If the ownership change was made in contemplation of death, the payout of the policy could be subject to taxes.
Setting Up an ILIT
A more secure way to avoid the estate tax on a life insurance payout is to use the policy to fund an irrevocable life insurance trust (commonly called an ILIT). An ILIT is a type of trust that can’t be rescinded, amended, or modified by its grantor (or creator – the person being insured) after its creation. Instead, the grantor gives all control of the assets managed by the trust to a “trustee” who oversees the distribution of those assets according to the trust agreement.
The benefit here is that the official trust agreement is a legal document listing your wishes, and it’s much easier to enforce how you’d like your estate to be distributed if things are set in stone up front.
If a person is getting insurance and wants the payout to go into an ILIT, most of the time, they will set up a new trust that will use the life insurance policy as an asset, and establish someone they trust as a trustee. That way, the life insurance payout is kept separate from the estate, meaning that it isn’t taxed.
A Quick Recap
For 99% of people looking for policies, the payout won’t be taxed. The payouts from term life policies are almost always tax-free, except in situations where the person being insured, the policy’s owner, and the beneficiary of the policy are all different people (agents refer to this type of arrangement as the “unholy trinity” or the “Goodman Triangle,” based on the court case that established this rule), or if they would put your estate over the estate tax threshold.
Permanent life insurance policies’ payouts may be taxed, but only in situations where you take advantage of their ability to accumulate value and serve as short-term loans from your insurance company.
When in doubt as to whether or not you need to take taxes into account on your policy, your agent will be able to help. Simply get in touch and run through your situation, and they’ll give you a good idea on what to expect.
Photo Credit to Jason Rogers