Do You Pay Taxes on A Life Insurance Policy?

When it comes to taxes, there are very few hard and fast rules except — you have to pay them. Even so, one of the most frequently asked questions we receive at the MB Group is "Do you have to pay taxes on a life insurance policy?" Contrary to the previous generalization, proceeds from a life insurance policy are typically not taxed as income. There are, however, three different scenarios where you may have to pay taxes on the insurance policy. Let's take a closer look at the three instances. 

The Life Insurance Beneficiary Is Late Claiming the Death Benefit

In most instances, the death benefit is claimed by the beneficiaries or beneficiary shortly after the insured party is deceased. While it is the most common and ideal scenario, there are instances where this doesn't happen succinctly. Instead, the insurance company will be required to hold the death benefit. Examples of when the insurance company is required to hold the death benefit include:

• There is a dispute by the beneficiaries.
• The beneficiaries or beneficiary are not able to be found.
• The insurance company must investigate the insured's cause of death.
• The insured's death requires or is subject to a criminal investigation.
• The insured passed on foreign soil.
• The beneficiary or beneficiaries request the insurance company to hold the death benefit.

The Death Benefit Is Paid to the Insured Estate

In the event the insurance company is required to hold the death benefit during the resolution of these issues, the death benefit will generate interest. And this interest will be taxed as income to the beneficiary. As an insurance beneficiary, the best way to avoid taxation on the interest of the benefit is to claim it in a timely manner. However, this isn't always possible or within your scope of control. In this case, you have no other option but to pay the taxes. 

When the insured party hasn't been properly advised by an experienced financial professional, they may choose to name their estate as the life insurance policy beneficiary. After being paid into the insured's estate, the estate will be dispersed to the heirs of the insured. And then, the heirs may be taxed on their inheritance. This scenario applies to different types of accounts, such as annuities and IRAs. 

When Are Estate Taxes Triggered

In 2021, estate taxes aren't triggered unless the estate's value exceeds $11.7 million million, while the exemption amount was increased to $12,060,000 in 2022. The maximum tax rate for estates is 40%. Most people assume that if the life insurance benefit is below the threshold, heirs will not have to pay taxes. 

And this may be true if there are no other assets in the estate. However, when the value of the estate — including retirement accounts, real property, collections, savings, and other belongings — exceeds the threshold amount, heirs may be forced to pay a hefty estate tax. 

Avoid the Estate Tax by Transferring Ownership of the Policy

One of the most effective ways to avoid estate taxes on insurance proceeds is to have ownership of the policy transferred. If someone other than you owns the policy at the time of your death, the proceeds from the insurance policy will not be calculated as part of your estate. Here are a few key steps in the process of transferring ownership of the policy to prevent your heirs from having to pay estate taxes:

1. Select a competent adult as the new owner who can also be a beneficiary.
2. Contact your insurance company to request the proper transfer of ownership forms. 
3. Request written confirmation from your insurance company verifying the new assignment. 

But before you transfer ownership of your policy, make sure you understand the following:

• You rescind the right to make alterations to the policy. You will need to request the new owner make the changes for you. 
• Once completed, all changes are irrevocable. 
• The new owner will then be required to continue paying premiums on the policy. One way to ensure the premiums are paid is by gifting the new owner up to $15,000. You are able to do so without any additional tax implications. 

Avoid the Estate Tax by Forming a Life Insurance Trust

Another highly-effective way of circumventing the estate tax on proceeds from insurance is to create a life insurance trust. This irrevocable trust is established with a life insurance policy as the asset. It allows the grantor of the policy to exempt assets away from their estate. When the policy is placed in the trust, the insured individual will no longer own the policy. Instead, it will be managed by the trustee on behalf of the beneficiaries of the policy when the insured party is deceased. This option is often utilized when the beneficiary of the policy is either an adult child with special needs or a minor child. 

The Insured Party Withdraws Funds from the Whole Life Policy

Certain insurance policies — such as universal life or whole life insurance — accrue value over time, which is tax-deferred. These policies tend to allow the owner to borrow or withdraw from the policy. In the event the insured withdraws more than they contributed in the form of premium payments, which is known as the basis, any overage will be taxed as income to the insured. 

Contact The MB Group Today

Planning for the future can be a challenge, but it is always necessary. And when it comes to leaving an inheritance to those you love, the importance of strategic planning increases exponentially. Fortunately, the MB Group specializes in helping high net-worth individuals — such as physicians, attorneys, and business owners — plan for the future they've always envisioned for themselves and loved ones.

Contact the MB Group today to get started.