MoneyWise’s recent article, titled “Are Life Insurance Benefits Taxable?” explains that although the proceeds from a life insurance policy are usually tax-free, there are some exceptions. Life insurance payouts may be subject to taxes in the following situations:
A high-value estate. The federal estate tax exemption is $11.58 million this year, so if you leave an estate worth more than that, the IRS will charge a tax of 18% to 40% on the excess amount. It’s possible that life insurance proceeds could get taxed if they're part of a high-dollar estate. To avoid this, you could create an irrevocable living trust to shield your assets from taxation. Ask an experienced estate planning attorney for help.
State inheritance or estate tax. Estate and inheritance tax laws are different in every state, so your estate or heirs may have to pay taxes on the death benefit, depending on where you reside. There are six states that have inheritance taxes (IA, KY, MD, NE, NJ, and PA). There are also a dozen states and the District of Columbia that have their own estate taxes (CT, HI, IL, ME, MD, MA, MN, NY, OR, RI, VT, and WA).
Gifts. You can also avoid estate or inheritance taxes by transferring your life insurance policy to a beneficiary while you're still around. You may have to pay a federal gift tax on the value of the policy when you do it, but the policy will be worth far less than the eventual death benefit. You can gift up to $15,000 a year to an individual without any tax. Remember that the policy's new owner will still have to make the payments.
The death benefit skips a generation. If you decide to skip your child and give the death benefit to your grandchild, the money would be considered taxable income by the IRS. That’s due to the "generation-skipping transfer tax," which applies if you give any gift or inheritance to a family member who's more than one generation younger than you — or to a nonrelative who's more than 37½ years younger.
Life insurance installment pay-out. While life insurance benefits are typically paid out in a lump sum, some people opt to have their benefits paid out over time. If you do this, tell your heirs that they’ll have taxes on any interest that's added to the benefits while they're being kept by the insurance company.
Withdrawal from your cash value of life insurance. With permanent life insurance policies that cover you for life (as opposed to time term life), there’s a savings component called “cash value.” During the life of the policy, some of your paid premiums fund the cash-value account. You can make a withdrawal from this amount, provided you make a withdrawal that’s less than the amount you've paid into the policy. Otherwise, it’s taxed.
Group life insurance policies. Many companies offer life insurance as a benefit to their employees. If you have a policy at your job, the premiums won’t be taxable income unless the promised life insurance payout is more than $50,000.
Selling your life insurance policy. If you sell your life insurance policy for cash to a buyer or investor who will continue to make the payments and will receive the death benefit when you die, you'll have taxes on any income from the sale.
If you still have questions about how insurance contracts work, speak to an experienced estate planning attorney.
Reference: MoneyWise (Oct. 12, 2020) “Are Life Insurance Benefits Taxable?”