If you have loved ones who depend on you financially, you need life insurance. Why? The answer is simple.
A life insurance policy payout will help your loved ones continue to pay the bills and cover your funeral expenses when you’re no longer there to support them. “You need to provide for them at the end of your life,” says Sean Mullaney, a Certified Public Accountant and president of Mullaney Financial and Tax.
Because a life insurance death benefit can be a lifeline for families, federal and state tax law is designed to protect insurance payouts, Mullaney says. That’s right – even though nothing is certain except death and taxes, death benefits usually escape taxes.
However, there are a few instances when a life insurance death benefit could be subject to taxes. 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 types of life insurance, term and permanent life insurance.
With term life insurance, coverage lasts for a specific number of years and is typically one of the more affordable types of life insurance. For example, a healthy 30-year-old woman could purchase a 20-year Haven Term policy, issued by MassMutual, with a $250,000 benefit for starting at $14.99 a month. If you die during the term of your policy, your beneficiaries can file a claim with the insurance company 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 these types of life insurance are generally not taxable to beneficiaries.
“If you look at the Congressional committee reports from the early 20th century pertaining to this provision of the income tax code, you’ll see that there is this strong concern for ‘widows and orphans,’” says Logan Allec, a CPA and owner of personal finance site Money Done Right. “So this exemption of life insurance proceeds is really rooted in social concerns, and this exemption has persisted to this day.”
How death benefit payment options might affect taxability
Life insurance companies typically offer a few different 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 choose to receive a payout in installments over time, a portion of these payments could be taxable.
“If you receive life insurance proceeds in separate payments over time, and the sum of these installments is greater than the amount you would have received from the insurance company if you had merely taken a lump sum upon the death of the insured, then a portion of these payments to you is considered interest,” Allec says. That interest can be taxed at your ordinary income tax rate.
You should receive a Form 1099-INT from the insurance company reporting your taxable interest, Mullaney says. You also could be hit with an additional tax on that interest if you are a high income earner.
Single taxpayers with a modified adjusted gross income (MAGI) of $200,000 or more and married taxpayers filing jointly with a MAGI of $250,000 or more must pay a 3.8% net investment income tax – also known as the Medicare surtax – on investment income such as interest.
Estate taxes and life insurance payouts
People with a large life insurance death benefit used to be worried about the estate tax, Mullaney says. That’s because the limit on assets – including insurance – that could be passed onto heirs tax-free was much lower than it is now.
For example, in 2004, an estate tax return had to be filed for estates exceeding $1.5 million, according to the IRS. For 2020, a federal estate tax exemption covers estates up to $11.58 million. “If you have a term life policy and it’s included in your estate, you don’t have to worry about the estate tax most likely,” Mullaney says.
If you have a large estate, though, Allec suggests working with a tax planning professional to discuss tax minimization strategies.
To keep your insurance payout out of your estate, “it may be advisable to transfer your policy’s ownership to someone else, perhaps the beneficiary,” Allec says. “Another strategy is to transfer the ownership of your life insurance policy to an irrevocable life insurance trust, where the proceeds of a life insurance policy may be insulated from estate taxes, subject to certain requirements. Again, work with a tax planning professional to see what may suit your specific situation.
Accelerated death benefits and taxes
Your life insurance company might offer an accelerated death benefit rider – a rider that can be added to your policy that would allow you to collect a portion of your death benefit while you’re alive to pay for medical care if you’re terminally ill. There can be an additional charge for this rider, but with the Haven Term policy, issued by MassMutual, it is included in the policy, and an administrative fee is charged if the rider is exercised.
Generally, you can receive accelerated death benefits tax-free if you have been certified by a doctor as terminally ill and are expected to die within 12-24 months (depending on the terms of the policy). If you are chronically – but not terminally ill – you still can qualify for the tax exclusion if you use payouts for qualified long-term care expenses, Mullaney says. Ask your tax planner about exceptions that may exist.
Cash value payouts and taxes
Permanent life insurance policies have a cash accumulation feature. In addition to offering the death benefit, these policies build cash value over time that can be tapped while you’re alive. However, borrowing against cash value increases the chances that the policy will lapse, reduces the cash value and death benefit, and may result in a tax bill if the policy terminates before the death of the insured. Additionally, participating policies have the potential to receive dividends, however it’s important to note that dividends are not guaranteed.
The primary reason to buy life insurance is the need for the death benefit. But in addition, permanent life insurance policies can also be used to supplement income in retirement.
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Life insurance settlements and taxes
Another way to get access to life insurance benefits before you die to pay for your care is with what is called a life insurance settlement, known as a viatical settlement. There are companies that buy life insurance policies from people who are terminally ill for more than the cash surrender value but less than the face value.
The money you would get from a viatical settlement would be tax-free if you were certified by a doctor as terminally ill and expected to die in the next 24 months, Mullaney says. However, the third party that buys your policy will have to pay taxes on the payout it collects from the policy when you die.
Group life insurance and taxes
You probably receive some kind of life insurance coverage at work. If you have employer-provided life insurance, known as group life insurance, any coverage over $50,000 is treated as taxable income, but any amount under $50,000 is not taxed.
Group life insurance can be a nice addition to your benefits package, especially if it’s free or nearly free. But these policies can sometimes fall short if you have a growing family or your life insurance needs change throughout your career.
Use an online life insurance calculator to help you figure out your coverage needs.
Peace of mind and taxes
Every tax situation is different. If you’re worried about the taxability of your life insurance payout, you should consult with a tax professional.
If you are a Haven Life customer and have questions about whether your policy’s payout is taxable, the customer success team is available to answer your questions.
If you don’t have life insurance, consider 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 policy rate.
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Cameron Huddleston is the author of Mom and Dad, We Need to Talk: How to Have Essential Conversations With Your Parents About Their Finances. She also is an award-winning journalist who has been writing about personal finance for more than 18 years. You can learn more about her at CameronHuddleston.com. Opinions are those of the author or the person interviewed.
The information provided is not written or intended as specific tax or legal advice. Haven Life Insurance Agency does not provide tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.
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