When thinking about your estate and beneficiaries, it can be easy to overlook taxes. But, for the people that do have life insurance and think about these things, one of the most common questions is: Are life insurance payouts taxable?
First, congratulations!, You did everything right! You paid your life insurance premiums your entire life, so your loved ones will have funds available after you pass on. But did you leave them enough to pay the tax bill?
It is important to have a tax plan, not just for yourself, but for your estate as well. It can be heartbreaking when someone thought they were leaving their loved ones financially well, only for those loved ones to realize they’re left with a huge, unexpected tax bill.
Most of the time, life insurance proceeds are not taxable. However, there may be fees due to the probate court in your area, depending on your state laws. And life insurance proceeds can be taxable in certain circumstances. Make sure you plan accordingly, and talk to your tax professional and estate planner about your specific situation.
Lump Sum Payout. When your life insurance beneficiary receives a lump sum payout, there are no federal income taxes due on the amount of the life insurance proceeds. Most life insurance policies are paid out this way. This means most life insurance payouts are not taxable.
Example. Robert took out an $100,000 life insurance policy with the entire face value ($100,000) to be paid to his wife, Anne. If Anne is not living when Robert passes, it goes to their son Marc.
In the example above, regardless of who gets the $100,000 - Anne or Marc, because they are getting the full amount (lump sum), they will not owe any federal income taxes on the amount they receive. That means the $100,000 passes from Robert to his beneficiary tax free. If Robert had left half of the $100,000 to Anne and half to Marc, there would still be no taxes owed. This is because they are still receiving a lump sum. It does not matter that they are sharing the death benefit.
Cash Value Withdraw. If you withdraw cash value from your life insurance policy, it is not taxable if the amount you withdraw is not more than what you paid for the life insurance. There are many types of life insurance. Two of the most common are permanent life insurance policies and term life. Permanent life insurance policies usually build up a cash value over the life of the policy. However, it is rare for it to equal more than what was paid for the life insurance, although not impossible.
Example. Robert’s life insurance policy had built up a cash value of $5,000. He had paid $12,000 for the life insurance policy over the entire time he had it. He decided to surrender the policy. He used the cash value to purchase a cheaper term life insurance policy. He kept the death benefit the same for his new policy - $100,000.
Regardless of what Robert did with the $5,000 he withdrew from the cash value of his life insurance policy, it is not taxable. Depending on the type of policy he has, he may be able to withdraw the cash value and use it to buy the fishing boat he’s always wanted or surrender the policy completely. For taxes, it does not matter if he replaced the life insurance policy or not. What does matter is that the amount of the cash value withdrawn is less than the amount paid for the policy. In Robert’s situation, it was. The $5,000 he withdrew is less than the $12,000 he paid. He would not owe any federal income taxes on the withdrawal. It is rare for someone’s cash value to equal more than what they have paid for the life insurance policy.
Life insurance payouts are taxable when:
The first three circumstances rarely happen. Although the fourth situation doesn’t happen often, you will see it arise occasionally. In the example above, if Robert’s mother, Delores had purchased the life insurance policy on Robert and maintained status as the owner, the death benefit would be taxable to whoever received it, either Anne or Marc. This is because Delores was the owner, Robert was the person insured, and Anne was the beneficiary. This happens occasionally because parents will purchase life insurance on their children and forget to change ownership of the policy when the child grows up. An easy way to avoid this is to change the ownership of the policy to the same person who is insured. If Delores had changed the ownership to Robert, the death benefit lump sum payout would not have been taxable.
Life insurance payouts rarely are taxable. However, make sure you contact your licensed tax professional to develop a tax plan. A little homework now could save your loved ones thousands of dollars in the future. In the example above, if Robert’s mom, Delores, maintained ownership of the life insurance policy, and Robert passed away with Anne as the beneficiary with a 24% tax rate, Anne would have to pay $24,000 of the $100,000 for federal income taxes. With a little tax planning, situations like this easily can be avoided, saving your loved ones and you thousands. Schedule an appointment today with Dayton’s accounting and tax preparation professionals at Gudorf Tax Group to develop a tax plan that works for you and protects your family from an unexpected tax bill.