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Death & Taxes: Do I Pay Taxes On A Life Insurance Payout?

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Monday, June 29, 2015

Death & Taxes: Do I Pay Taxes On A Life Insurance Payout?

"Nothing is certain in life except death and taxes."

We're all familiar with that depressing old adage. But what about taxes after death? When we die, will our loved ones have to fork over money to Uncle Sam to receive a life insurance payout?

For most of us, the answer is no. Here's why life insurance proceeds aren't typically taxable.

Is Life Insurance Taxable?

The IRS doesn't consider death benefits to be reportable income. So, after you die, your beneficiaries won't have to pay income tax on the proceeds they get from your life insurance policy.

But don't stop reading, because you might not be off the hook just yet. Your policy could be subject to other taxes, for three reasons.

1) Your Payout Earns Interest

When you buy a policy, you decide if your beneficiaries receive the payout in one lump sum, or in a series of installments. If you opt to have your insurer dole out the proceeds in installments, the money they hold onto earns interest over time. That interest is considered taxable income.

How To Get Around This Tax:

Have your family receive the payout in one lump sum. If your family receives the death benefit over time, they'll pay income tax on its earned interest.

Not sure how where to start? Talk to an agent. They'll help you pick a policy that covers your family's needs.

2) You Have Valuable Assets

If you still own your life insurance policy when you die, that policy is included in your estate. When your estate gets passed on to your beneficiaries, your assets (including the proceeds of your policy) will be subject to an estate tax.

Luckily for your beneficiaries, most estates aren't worth enough to be hit with an estate tax. The IRS won't bother taxing your beneficiaries unless you leave behind assets worth more than $5.4 million.

How To Get Around This Tax:

Unless your estate (including your life insurance policy) runs over $5.4 million, you don't have to do anything. Your beneficiary won't pay an estate tax for a death benefit.

Think you have enough assets to be subject to an estate tax? You'll want to transfer ownership of your policy to someone else. You have two ways to do this:

  • Transfer your policy to a trusted adult

Put your spouse, friend, adult child, or financial advisor in charge of your policy, and your beneficiaries won't pay an estate tax on your life insurance payout.

A word of warning: Before you pass off ownership to someone else, make sure you can trust them. If you have a falling out with the new policy owner, or they don't keep up with the premium payments, you'll lose your policy for good. You and your beneficiaries will be completely out of luck.

  • Transfer your policy to a trust

If you don't want to hand over your policy to someone else, you can put it in an irrevocable life insurance trust (ILIT). With an ILIT, you decide who becomes the trustee and beneficiary. (Obviously, neither the trustee or beneficiary can be you!)

As with a transfer to another adult, a transfer to a trust means you give up ownership of that policy. Your trust owns the policy, and your trustee is responsible for paying the premiums to maintain it. You also won't be able to change the policy's beneficiaries.

To figure out how you can transfer a life insurance policy, get help from an insurance agent. Insurance Clarity can put you in touch with an expert.

3) You "Gift" Your Policy

When you buy a whole life insurance policy, you build cash value over time. You can use that cash reserve to get a loan, save up for retirement, or pay for life insurance premiums.

However, if your whole life policy builds more than $14,000 cash value before you transfer it to someone else, your policy's new owner has to pay a gift tax on the remaining amount when you die. Say you pick a $300,000 whole life policy, and it builds up $18,000 cash value. You decide to transfer the policy to your daughter. When you die, your daughter has to pay a gift tax on $4,000 of cash value.

How To Get Around This Tax:

Transfer your policy sooner than later, before your policy builds up a taxable cash value.

Your Family Probably Won't Owe Uncle Sam

Will your beneficiaries get taxed on your life insurance payout? Probably not. However, there are three exceptions:

  1. If your beneficiaries earn interest on the payout (instead of getting it in one lump sum), they'll pay income tax on the earned interest.

  2. If the value of your estate totals more than $5.4 million, and you don't transfer ownership of your policy to an adult or a trust, your beneficiaries will pay an estate tax on the life insurance death benefit.

  3. If your policy has a cash value over $14,000, and you transfer it to a beneficiary, they'll have to pay a gift tax when you die.

A life insurance payout can drastically improve the lives of your loved ones. When you're ready to buy life insurance, make sure you get help from an insurance expert. With the right policy, you'll be sure your family (not Uncle Sam!) gets the biggest dividends from a death benefit.