In addition to just paying out a benefit upon one’s death, life insurance can be used as part of an overall strategy for retirement, estate, and financial planning.
These types of policies can help to protect assets, and if structured properly, can also be set up such that the owner or beneficiaries are not burdened with a hefty tax upon receipt of the policy’s proceeds – whether that be through income installments or as one lump sum benefit payment.
When Life Insurance Isn’t Taxable
When compared with many other financial products, life insurance provides some great tax-related advantages.
These can come in many forms, including:
- Death Benefits that are income tax-free
- Tax-Deferred growth of cash value build up
- Use of life insurance benefits to reduce or eliminate estate taxes
Death Benefit Proceeds
One of the biggest tax-related benefits to life insurance is that the death benefits are received free of income taxation to the policy beneficiary (or beneficiaries).
This can be extremely beneficial to the insured’s survivors, as they will know exactly how much will be available for paying final expenses, as well as other debts and obligations that may be due.
A key reason for this is that the federal government is reluctant to impose income tax on a product that is essentially designed to provide a financial cushion to those who have lost an income earner or other loved one who had provided some type of financial support to them.
Therefore, it is felt that life insurance death benefits provide indemnity or restoration.
Life Insurance Cash Value
Permanent life insurance policies typically allow a savings or investment component as a part of the policy.
Here, a portion of the policy holder’s premium is deposited and allowed to accumulate as cash. And it is allowed to grow based on the performance of an underlying market or investment.
The cash value portion of a permanent life insurance policy is not taxed on an annual basis per IRS guidelines.
Rather, these funds are allowed to grow on a tax-deferred basis. And they are only taxed at the time of withdrawal. This can provide them with the ability to truly compound over time.
The tax deferral can also offer an additional potential benefit should the policy owner wait to withdraw funds until after they have retired.
This is because, at that time, he or she may be in a lower income tax bracket, therefore being charged an even lower amount of income tax on the withdrawn funds than if they have been taken out an at an earlier date.
Withdrawal versus Loan
Life insurance policyholders are also allowed to borrow against the cash in their policy.
The proceeds from such loans are generally not taxable unless the policy is considered to be a MEC (modified endowment contract), in which case the funds will be treated as if they were “income-out-first.”
Estate Tax Issues
Life insurance death benefit proceeds are free from income taxation. But they are included in a decedent’s overall estate. As long as the insured is also the owner of the life insurance policy.
Therefore, unless steps have been taken to remove a policy from an individual’s ownership, the amount of a policy’s death benefit will be included in one’s taxable estate. And will thus be included in the amount to be taxed.
For many years, however, life insurance has also been used as a tool for reducing or eliminating the estate taxes that are due.
Once a policy’s proceeds have been successfully removed from one’s estate, they can then be used for paying estate taxes. Without being taxed as a part of the overall estate.
Removing Proceeds from the Estate
One way to remove life insurance policy proceeds from an insured’s estate is to set up an Irrevocable Life Insurance Trust, or ILIT, to instead become the owner of the life insurance policy.
The ILIT is irrevocable. This means that the insured generally will not be able to change the terms of the trust once it has been signed. Also, another individual must also be selected as the trustee of the ILIT.
Likewise, the insured also cannot be the beneficiary of the trust. However, his or her children can be – and oftentimes are.
Also, the ILIT cannot be made payable to the insured’s estate or to his or her revocable living trust (if applicable), as the insured’s ability during his or her lifetime to change their will or trust will also then result in the ability to change the beneficial enjoyment of the life insurance policy’s proceeds – in turn, essentially bringing back the policy into the estate.
When Life Insurance Is Taxed
For the 99% of policyholders and beneficiaries, they won’t have to worry about any taxes.
There are a few cases and circumstances where taxes are going to come in.
If The Beneficiary Chooses Payments
One of those is if the beneficiary decides to get the payout in payments instead of one single lump sum. This is why we always tell beneficiaries to get the money at one time.
If they do this, the life insurance company is going to hold the money and pay the beneficiary monthly/quarterly/or annual payments. The money will stay with the insurance company, and that interest will be taxable.
If You Take Out A Loan Against The Cash Value
Say you take out a loan against the cash value of a whole life insurance plan, but the loan isn’t paid back. In this case, you’re going to be subject to taxes.
If Your Estate Value Is Too High
One rare case of life insurance payouts being taxed is when it comes to taxes.
If your estate value is high enough, then the money from the insurance payout could get taxed.
The threshold is $11 million in 2018, which means most people don’t have to worry about this being a problem.
The Bottom Line
Not having to bother with taxes on life insurance payouts is what makes them one of the most attractive ways to provide for a family.
Taxes are a way of life, but they shouldn’t prevent your family from having enough money if you pass away.
Maybe the idea of dealing with taxes and life insurance is too much for you to handle on your own. We would be happy to rescue you from the craziness.
Yes, we are an independent agency. This means our brokers can sell you a policy from just about any company out there.
But we want to do more than just sell plans, we want to be a guide and assistant. Even if we don’t sell you a policy, we would be happy to share our expertise on the relationship between taxes and life insurance.
Call us today for a quote at 1-800-712-8519.
