Life insurance is an excellent financial vehicle, designed to replace income for your loved ones if you were to pass away. It can even provide a source of wealth for your beneficiaries after your death. One more great aspect of life insurance is that the proceeds from your policy will usually be tax-free.
While there are some instances where life insurance payouts are taxed, this is usually because the insured leaves behind a high-value estate (and even then, there are steps you can take to protect your beneficiaries from a high tax bill). For the rest of us, we can expect our policy benefits to be paid out income tax-free to our beneficiaries. This tax-advantaged transfer of funds makes life insurance a very sound addition to any financial plan.
Let’s take a look at some of the the tax benefits that come along with life insurance, and how you can use them to your advantage.
Benefits Usually Are Not Taxed
There are a number of occasions when life insurance payouts are entirely tax-free. This means that your beneficiaries will receive a lump sum after you pass away, without having to worry about a high tax bill when the government comes knocking.
This tax benefit means that you can plan for the true amount of coverage that your loved ones will need, without having to add in tens of thousands of dollars to cover Uncle Sam’s cut.
Here are a few instances when you (or your family) can rest easy with a tax-free insurance policy payout.
Thanks to a provision in the U.S. Federal Estate & Gift Tax Law, your spouse will avoid paying taxes even if your estate includes a large life insurance policy, and even if the total value you leave behind is well beyond the IRS’s estate tax threshold. This provision, called the unlimited marital deduction, states that you can transfer assets to your spouse (as long as they’re a legal citizen) at any time, without a tax penalty – before or after death.
If a surviving spouse is your sole life insurance beneficiary, you can plan for them to receive the entirety of your life insurance benefits without a tax bill attached. Even if they will be taking control of a large estate, taxes won’t be incurred.
The primary purpose for buying a life insurance policy is to provide for your loved ones after you pass away. This death benefit is meant to be a reimbursement for their loss (of a loved one, of a support person, etc.); therefore, according to Publication 525 from the IRS, it is not considered “income.” As a result, your beneficiaries won’t be taxed on the payout that they receive from your life insurance.
The only caveat here is that if your estate is very large, the life insurance payout will be considered part of your estate. If the total estate value crosses the IRS threshold, and is therefore subject to estate tax, the insurance payout can also be subject to this tax.
We’ll talk more below about what this tax threshold is and how you can save your beneficiaries from worrying about it.
Surrendering Your Policy
If you choose to surrender your life insurance policy and opt for a “buy out” instead, you won’t have to pay taxes on the lump sum received. As long as the money you get from selling the policy is less than you’ve paid in premiums thus far, there are no taxes incurred.
When Taxes Crop Up
There are a few situations where your life insurance payout may catch Uncle Sam’s attention. With the right financial planning, though, you can still avoid leaving your loved ones with a big, fat tax bill on the benefits they receive.
Your Spouse Isn’t a Citizen
If your spouse is a U.S. citizen, they can assume control of your assets following your death without any tax penalties involved and without limit. This is due to the unlimited marital deduction mentioned above. However, you run into an issue if you have a large estate and a non-citizen spouse.
In this case, the unlimited marital deduction wouldn’t apply. Any estate that you leave behind for him or her would be treated just like any other gift, such as what you leave behind for a child or other beneficiary.
Your Estate is Worth Too Much
Under federal law, everyone is able to leave a certain value of assets behind without being subject to federal tax. Thanks to the new tax law, this amount is $10,000,000 in 2018. This means that you can leave up to $10,000,000 to anyone you wish – including a non-citizen spouse or your heirs – without having to worry about taxes on the gift. The problem, of course, is if you have an estate (including your life insurance policy) worth more than that.
If that’s the case, you could look into creating an irrevocable life insurance trust (ILIT) and designating the trust as the beneficiary of your life insurance policy. This method keeps your life insurance proceeds from becoming part of your estate, avoiding the high taxes that would follow.
The ILIT is a great option for a non-citizen spouse, as well, which we mentioned above. Even if you don’t need it for tax sheltering purposes, it can still be a wonderful option if you would be leaving a large sum of money behind for a minor child or irresponsible adult. This allows the trust to dole out funds in regular disbursements, rather than one large lump sum.
Your Beneficiaries Earn Interest
While insurance proceeds (below the maximums mentioned already) are tax-free, the interest they may earn is not.
Your beneficiaries should know what to expect if they will be receiving a large payout following your death. This lump sum will not be considered taxable income, of course. If they put it in an interest-bearing account or invest it, though, the future proceeds will need to be claimed as normal income. They will be required to pay taxes on its growth moving forward, but not the original investment.
Life insurance payouts are beneficial financial vehicles, which can provide for your loved ones in a tax-free manner following your death. Most of us (or at least, our beneficiaries) won’t ever need to worry about estate taxes on life insurance proceeds.
If you have an estate worth more than $10 million (as of 2018), though, or a surviving spouse who isn’t a U.S. citizen, it may be worth considering an irrevocable trust. This allows you to still enjoy the same tax benefits, while passing on a larger sum to your family.
Disclaimer: Please note that this article does not serve as professional tax advice. Please consult with a licensed tax advisor when making financial decisions.