Benefits from life insurance policies are generally not subject to taxation. Although if you’re a primary beneficiary, you shouldn’t go crazy with the cash just yet. Gains from investing the money or the policyholder’s high net worth are two examples of circumstances that could trigger taxation of the earnings.
Knowing the specifics of when and how such taxes apply will help you plan accordingly. On that note, let’s take a detailed look into how taxation around life insurance payouts works.
Are Life Insurance Proceedings Taxable?
Perhaps you’ve wondered, “Is life insurance subjected to tax?” The IRS rules that the recipient of a life insurance payout does not have to include that money in their taxable income. But there are always a few outliers. For example, a beneficiary who inherits the insured’s life insurance policy must include the interest they’ve earned from the policy as part of their taxable income.
In addition, if the payout is in the form of cash or other forms of compensation, the recipient could be required to include some or all of it in their taxable income. In certain situations, though, you may be required to make a tax payment like:
When Death Benefit Is Paid In Full
In most cases, the recipient of a life insurance policy will get the death benefit in a single lump amount, but the beneficiary also has the option of receiving the death benefit in periodic payments or an annuity.
In such a case, the life insurance company will usually invest the money and pay out the death benefit in installments over time. Installments ensure a regular flow of cash, but any interest earned on a death benefit is taxable. However, the initial death benefit usually isn’t.
When Your Policy Has A Cash Value
This one might not be a taxation problem, but it will have an impact on the recipient. A cash value coverage allows the policyholder access to policy funds through borrowing. If you take out a loan on your life insurance plan and don’t pay off the loan, the life insurance company might take off the amount you owe from the death benefit.
Modified endowment contracts are cash value policies with premiums paid more than the limit for continued favorable tax treatment. Under a MEC, dividends from the cash value are offset by taxable profits before withdrawing any contributions. If a life insurance coverage is classified as a Modified Endowment Contract, then the cash value cannot be withdrawn tax-free.
When The Death Benefit Gets Included In Your Estate
Individuals in the US are allowed an estate tax exemption of $12.06 million in 2022, while couples jointly filing will be allowed an exemption of $24.12 million. If your estate’s taxable worth is higher than this amount when you pass away in 2022, the Internal Revenue Service will assess a tax on your estate.
Although you may choose a beneficiary for your life insurance payout, the Internal Revenue Service will nonetheless consider it part of your taxable estate if you pass away while the plan is in effect. The sum received may cause the overall worth of your estate to exceed the threshold, triggering an estate tax that your heirs must pay within nine months of your demise.
Life insurance payouts can be utilized to cover estate taxes if a trust or will designate the estate as the beneficiary. However, if you select a beneficiary or beneficiaries, they will not be personally responsible for paying any estate tax on the life insurance payments they receive.
You can rest easy knowing that your family members won’t have to pay any estate taxes if your estate is valued below $12.06 million. It’s also worth noting that if your estate value exceeds the federal exemption amount, your surviving spouse will likely not be subject to any estate tax.
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