Life insurance helps us prepare for death, but what about the uncertainty caused by overlapping life insurance and taxes? Are life insurance payments taxable?
When life insurance is taxed
For most people, life insurance proceeds will not be taxable. But for some, life insurance will be taxable if it is included in real estate and exceeds a certain threshold.
Here are the scenarios in which the proceeds from life insurance are taxable:
- When the payment is made in installments instead of in full
- There are two options for getting a life insurance payment: in full or in installments.
- If the payment is made in installments, the interest accrued on the payments is taxable. The death grant is not taxable, only interest on installments.
- Installment plans can be beneficial for people who need money spread over a certain period of time or are not sure if they will be able to resist issuing a lump sum at once.
- If the fortune is worth over $ 11.4 million
Only spouses are exempt from taxation in life policies. Everyone else, such as a parent or sibling, will have to collect income from the property. This means that money is taxable if the property is large enough.
In 2019, the federal property tax exemption is USD 11.4 million for individuals. If someone had died and had property valued above this amount, any amount above the threshold would have been taxed at 40 percent.
When life insurance is NOT taxed
In these typical situations, inflows are not subject to income tax:
- Payment to the beneficiary after the death of someone
- The payout for the transfer is less than the amount paid
- Dividends are not taxable
- When payment is made for a terminally ill but still living person
Use of life insurance trusts to avoid taxation
The second way to remove proceeds from life insurance from your taxable property is to create an irrevocable life trust (ILIT). To complete the transfer of ownership, you cannot be a trustee and you cannot retain any rights to revoke the trust. In this case, the policy is trusted and you will no longer be considered the owner. Therefore, receipts are not included as part of your assets.
Why choose a trust property instead of transferring ownership to another person? One reason may be the desire to maintain some legal control over the policy. Or maybe you’re afraid that the individual owner may not pay contributions, and with confidence you can guarantee that all contributions will be paid immediately. If the beneficiaries of the proceeds are minor children from a previous marriage, ILIT will allow you to appoint a trusted family member as a trustee to deal with children’s money as per the terms of the trust document.
You probably won’t have to pay taxes on loans taken out under the policy
If you take out a loan against the cash value of the insurance policy, the loan amount is not taxable (except for MEC). This result occurs even if the loan is greater than the amount of contributions you have paid. Such a loan is not taxed as long as the policy applies.
If you take out a loan under the policy, the funeral grant and the monetary value of the policy will be reduced.