Life Insurance Income Tax And Estate Tax-Free

Wealth isn’t simply money; it’s being able to live your life freely. If you have wealth, you can ensure that your generation will be cared for long after you’re gone.…

November 18, 2022

Written by Ty Bongiovanni

Wealth isn’t simply money; it’s being able to live your life freely. If you have wealth, you can ensure that your generation will be cared for long after you’re gone. Wealth management is a broad term that encompasses many different aspects of financial planning, including tax planning.

As a business owner, entrepreneur, individual, or family, it’s important to know the various taxes that may impact you and your wealth. This blog post will focus on life insurance income tax and estate taxes. Keep reading to learn more.

What Is Life Insurance?

Life insurance is a contract between an insurer and a policyholder. The insurer agrees to pay a designated beneficiary a sum of money (the death benefit) in exchange for premiums the policyholder pays. The policyholder pays premiums until their death, at which point the death benefit is paid out to the beneficiary.

There are 2 types of life insurance policies:

  • Term life insurance: It provides coverage for a set period, after which the policy expires.
  • Whole life insurance: It provides coverage for the policyholder’s entire life and typically builds cash value over time.

Life Insurance Income Tax

Life insurance income tax is a tax that is levied on the benefits paid out by a life insurance policy. The tax is imposed on the recipient of the life insurance benefit, not the insurer. This type of tax is also known as a death benefit tax.

Also, remember that life insurance income tax differs from estate taxes. Estate taxes are levied on the value of the deceased person’s estate, not on the life insurance benefits paid to beneficiaries.

The Multiple Situations Where Life Insurance Income Is Taxable

Generally, life insurance proceeds are not taxable. However, there are a few situations in which the death benefit may be subject to income tax:

You Withdraw Money from Cash Value

Cash value life insurance policies let you access the money you’ve paid through withdrawals, loans, or by ending the policy. Some people get cash value life insurance for the sole purpose of being able to use that money later on.

When you pay premiums, the money generally goes to 3 places: cash value, insurance premium, and policy fees and costs. Money in your cash value account grows tax-free based on interest or investment gains, depending on the policy. However, withdrawing the money could result in a tax liability.

You Surrender the Life Insurance

If you no longer want or need your life insurance policy, you can surrender the policy back to the insurer. The amount of money received is called the cash value, and this is what you get minus any unpaid charges

The surrender charge is usually deducted within the first 10 or 20 years of owning the policy and gradually disappears over time. You won’t be taxed on the entire surrender value. The taxable amount is the difference between what you received and your policy basis.

You Took Out a Policy Loan, and the Life Insurance Ends

If your policy has cash value and you take out a loan against it, the loan isn’t taxable—but only if the policy is still active. However, you may be taxed if the policy ends before you pay off the loan. For example, coverage terminates if you surrender the policy or it lapses

The taxable amount is calculated on the loan portion that surpasses your policy basis. Remember, the policy basis is the amount you’ve paid in premiums. Interest and investment gains on cash value are used to compute “amounts above basis.”

You Sell the Life Insurance Policy

In some cases, you may be able to sell your life insurance policy in a process called life settlements. With this option, you receive a lump sum of cash from the buyer that’s typically more than the cash value but less than the death benefit.

The sale of the policy is considered a taxable event. You’ll have to pay taxes on the difference between the policy’s basis and the amount you received from the sale.

You Are Life Insurance Beneficiary Who Receives Interest on a Death Benefit

If you’re the beneficiary of a life insurance policy and the death benefit is paid to you in installments, any interest earned on those payments is taxable. The interest is considered taxable income and must be reported on your tax return. The good news is that the death benefit itself is not subject to income tax.

The Life Insurance Payout Goes Into a Taxable Estate

If a life insurance policyholder dies without naming a beneficiary or the named beneficiary has already died, the death benefit payout becomes part of the deceased person’s estate and may be subject to taxes.

You’re responsible for your own tax paperwork, including but not limited to state and local taxes; this is a lot of money, especially considering federal and state estate taxes. Although the federal government will not tax the first $12.06 million per person in 2022, state estate taxes may have far lower exemption levels.

A second possible scenario is that an estate is below the exemption level. Still, a big life insurance payment into the estate raises it above the exemption level and into the taxable territory. This problem should be avoidable by regularly updating primary and contingent life 

insurance beneficiaries.

Most Important Factors Of Life Insurance

There are a few key things to keep in mind regarding life insurance and taxes. Some of them are:

Estate Taxes

Estate taxes are imposed on the transfer of property at death. The tax is levied on the value of the decedent’s estate, which includes all real and personal property owned by the decedent at the time of death.

The federal government imposes an estate tax, as do some state governments. The federal estate tax rate is currently 40%. This means that for every $100 in value of the estate, the heir will owe $40 in estate taxes.

Income Taxes

The cash value in a life insurance policy is not subject to income tax as it grows; this provides a significant tax advantage for policyholders.

However, when the death benefit is paid out to beneficiaries, it’s considered taxable income. The beneficiary will owe taxes on the death benefit at their marginal tax rate.

Is The Cash Value In Life Insurance Policies Taxable?

With whole life insurance (as well as other permanent life insurance policies,) you gradually earn cash value over time. You can withdraw or borrow from the cash value when you have built up enough and your active policy.

The majority of this cash is tax-deferred, meaning you only pay income taxes if you withdraw money from the policy. And even then, the IRS levies a tax on only the amount that exceeds your policy basis — factoring in what you’ve paid in premiums and minus any dividends received.

If you withdraw less than the plan’s basis, your cash value is tax-free. Any withdrawals over the insurance coverage are taxable.

Situations Where The Cash Value Is Taxable

There are a few situations where the cash value would be taxable even if you don’t make a withdrawal. These include:

You Surrender The Policy

If you cancel a permanent life insurance policy, the insurer will pay out the policy’s cash value minus any fees associated with canceling. If this amount exceeds the policy’s cost, it is taxable.

If you give up a $10,000 policy and the basis is $5,000, the IRS considers the extra $5,000 income. The taxable amount reflects the policy’s investment gains.

You Sell The Policy

If you sell your life insurance policy to a third party, you may make more money than if you surrender it. This is because the selling price of the policy is not limited to the cash value amount but rather depends on a variety of criteria, such as your life expectancy, the death benefit, and premium costs.

If you’re looking to get out of your life insurance policy and buy a new one, trading it as part of a 1035 exchange may be the best route. This is because you wouldn’t have to pay capital gains tax on it instead of selling the property outright.

You Take Out A Loan Against The Cash Value

Even if you borrow more than the policy basis, tax-free cash value loans are deductible; this implies that you can borrow against your life insurance plan without paying taxes, as long as you repay it. The tax implications of failing to pay back the loan may be severe.

If you die before paying off the debt, any unpaid balance is subtracted from your death benefit, resulting in a lower amount paid to your beneficiaries.

Nesso Wealth In Connecticut Is Here To Help Your Wealth Grow

Are you looking for help with wealth management? Nesso Wealth is a Connecticut-based financial planning and investment firm that can assist you. We offer a comprehensive approach to wealth management, including tax planning.

Our goal at Nesso Wealth is to assist you in achieving your objectives, whether you’re just starting out, preparing for retirement, or far along in life. Our team of financial advisors will work with you to create a comprehensive plan that evaluates your current finances and sets you on the path to true financial freedom. 

Get in touch with us today if you’re interested in learning more about Nesso Wealth and how we can help you grow your wealth.

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