If you've family members who depend on you financially, you'll need life insurance coverage. Why? The answer is easy.
A life insurance policy payout can help your loved ones still settle the debts and canopy your funeral expenses when you are no longer there to support them. “You need to provide for them after your life,” says Sean Mullaney, a professional Public Accountant and president of Mullaney Financial and Tax.
Because an existence insurance death benefit could be a lifeline for families, state and federal tax law is designed to protect insurance payouts, Mullaney says. That's right – even though there is nothing certain except death and taxes, death benefits usually escape taxes.
However, there are a few instances when a life insurance death benefit could be after tax. It's important to be aware of these situations to limit the tax liability of a life insurance payout.
Why life insurance proceeds are usually not taxable
There are two primary kinds of life insurance, term and permanent life insurance.
With term life insurance, coverage lasts for a particular period of time and is typically one of the more affordable types of life insurance coverage. For instance, a proper 30-year-old woman could buy a 20-year Haven Term policy, from MassMutual, having a $250,000 benefit for starting at $14.99 per month. If you die during the term of your policy, your beneficiaries can file a claim with the insurance provider to collect the death benefit.
Permanent life insurance provides coverage that lasts a lifetime, as long as the premiums are paid.
Payouts from either of those kinds of life insurance commonly are not taxable to beneficiaries.
“If you appear in the Congressional committee reports from the early Twentieth century pertaining to this provision from the tax code, you’ll see that there's this strong concern for 'widows and orphans,'” says Logan Allec, an accountant los angeles and owner of personal finance site Money Done correctly. “So this exemption of life insurance proceeds is actually rooted in social concerns, which exemption has persisted even today.”
How death benefit payment options might affect taxability
Life insurance providers typically provide a various options to receive the death benefit payout from a policy. The default option is a lump-sum payment, which is generally tax-free.
However, if you or your beneficiaries decide to receive a payout in installments with time, some of those payments could be taxable.
“If you obtain life insurance proceeds in separate payments over time, and also the sum of these installments is larger than the amount you'd have received in the insurance company if you had merely taken a lump sum upon the death from the insured, a part of these payments to you is recognized as interest,” Allec says. That interest can be taxed at the ordinary tax rate.
You should get a Form 1099-INT in the insurance company reporting your taxable interest, Mullaney says. Additionally you could be hit with an additional tax with that interest if you're a high income earner.
Single taxpayers with a modified adjusted gross income (MAGI) of $200,000 or even more and married taxpayers filing jointly having a MAGI of $250,000 or even more must pay a 3.8% net investment tax – also referred to as the Medicare surtax – on investment income for example interest.
Estate taxes and life insurance payouts
People having a large life insurance coverage death benefit was once concerned about the estate tax, Mullaney says. That's because the limit on assets – including insurance – that may be passed onto heirs tax-free was reduced than now.
For example, in 2004, an estate taxes needed to be declared estates exceeding $1.5 million, according to the IRS. For 2021, a federal estate tax exemption covers estates up to $11.58 million. “If you have a term life insurance policy and it's as part of your estate, it's not necessary to worry about the estate tax probably,” Mullaney says.
If you have a large estate, though, Allec suggests working with a tax planning professional to go over tax minimization strategies.
To keep the insurance payout from your estate, “it might be advisable to transfer your policy’s ownership to a person else, probably the beneficiary,” Allec says. “Another strategy is to transfer the ownership of your life insurance policy to an irrevocable life insurance coverage trust, where the proceeds of a life insurance policy may be insulated from estate taxes, subject to the prerequisites. Again, make use of a tax planning professional to determine what may fit your specific situation.
Accelerated death benefits and taxes
Your life insurance company might present an accelerated death benefit rider – a rider that may be put into your policy that will allow you to collect some of the death benefit while you're alive to cover health care if you are terminally ill. There can be one more charge with this rider, but with the Haven Term policy, issued by MassMutual, it is contained in the policy, and an administrative fee is charged when the rider is exercised.
Generally, you can receive accelerated death benefits tax-free if you have been certified with a doctor as crictally ill and therefore are likely to die within 12-24 months (with respect to the terms of the policy). If you're chronically – but not crictally ill – you still can entitled to the tax exclusion if you use payouts for qualified long-term care expenses, Mullaney says. Ask your tax planner about exceptions that could exist.
Cash value payouts and taxes
Permanent life insurance policies possess a cash accumulation feature. In addition to offering the death benefit, these policies build cash value with time that can be tapped while you are alive. However, borrowing against cash value increases the chances that the policy will lapse, reduces the cash value and death benefit, and could result in a tax bill if the policy terminates before the death of the insured. Additionally, participating policies have the possibility to receive dividends, however it's important to note that dividends aren't guaranteed.
The primary reason to buy life insurance may be the demand for death benefit. And also, permanent life policies may also be used to supplement income in retirement.
Life insurance settlements and taxes
Another method of getting access to life insurance coverage benefits before you die to cover your care is with what is known as an existence insurance settlement, referred to as a viatical settlement. You will find firms that buy life policies from people who are crictally ill for more than the cash surrender value but under the face area value.
The money you can get from the viatical settlement could be tax-free should you be certified by a doctor as terminally ill and expected to die within the next Two years, Mullaney says. However, the 3rd party that buys your policy will have to pay taxes around the payout it collects in the policy whenever you die.
Group life insurance and taxes
You probably receive some type of insurance coverage at work. For those who have employer-provided life insurance, referred to as group life insurance coverage, any coverage over $50,000 is treated as taxable income, but any amount under $50,000 is not taxed.
Group life insurance coverage could be a nice accessory for your benefits package, especially if it's free or nearly free. However these policies can occasionally are unsuccessful for those who have an increasing family or perhaps your life insurance needs change throughout your career.
Use an online life insurance coverage calculator that will help you determine your coverage needs.
Peace of mind and taxes
Every tax situation differs. If you are concerned about the taxability of your life insurance payout, you should meet with a tax professional.
If you're a Haven Life customer and also have questions regarding whether your policy's payout is taxable, the customer success team is available to answer the questions you have.
If you don't have life insurance, think about the peace of mind that comes with financially protecting your loved ones in a way, that in most cases, is typically tax-free. Get your personalized life insurance coverage rate.