Is a Life Insurance Payout Considered Taxable Income?

Death and taxes are both inevitable. When you or a loved one passes on, will the recipients have to pay taxes on life insurance payouts?

Like most tax laws, the statutes governing life insurance payouts are not simple. There are detailed federal regulations and additional guidelines that differ by location on the state level. It is vital to know family members will have monetary provision in the event of a death, but if the benefits are gutted by taxes, how much money will be left for the life insurance beneficiary?

What Does the IRS Say?

In general, life insurance payouts are not counted as income for tax purposes. However, several scenarios could impose other types of tariffs on the proceeds besides income tax, such as estate taxes or gift taxes.

If the owner of the life insurance policy dies and their total assets including life insurance policies are valued at $5.43 million or more (as of 2015), an estate tax is levied against the total. The only way around this tax is by signing over a life insurance policy to the beneficiary at least three years before death. When the policy owner hands off ownership of the policy, they no longer control the contract in any way. They may not cancel it. If ownership of the policy is transferred but the original owner still exercises any legal right, the transference will be disallowed for estate tax purposes.

When transferring a life insurance policy with a present-day value of over $14,000, a gift tax will be levied after the original owner dies and the payouts are delivered to the new owner/beneficiary. The tax will only be on the amount the policy was worth at the time of transfer, not the total payout amount.

Is Interest Taxable?

When beneficiaries collect life insurance proceeds, some elect to transfer all the funds at once while some opt for annual installments. Regardless of when the money is collected, all interest is counted as income. Recipients must note interest income on all tax forms.

Are Life Insurance Premiums Tax Deductible?

So recipients can enjoy the tax-free benefits of life insurance payouts in the future, no one is allowed to write off life insurance premiums on their federal taxes. The only exception to this rule are those who fall under an employer-sponsored life insurance plan. Consult with a tax attorney regarding which expenses paid may be accounted for come tax time.

What About Life Insurance Proceeds Paid Before Death?

Terminally ill individuals may elect to withdraw funds from their life insurance policy before death. This allowance is acceptable to most insurance companies as long as the policy owner has a physician’s confirmation that they will likely pass within 24 months. In this case, none of the proceeds are considered income and will not be taxed.

What Happens at the State Level?

Every state has their own tax code governing life insurance proceeds. Washington has the highest estate tax at 20 percent. Maryland and New Jersey have an estate tax and an inheritance tax. In total, the District of Columbia and 15 states impose estate taxes and six states impose inheritance taxes.

Future financial security for loved ones is important, so build a detailed estate plan with an insurance expert today.

Sources:
http://www.irs.gov/Help-&-Resources/Tools-&-FAQs/FAQs-for-Individuals/Frequently-Asked-Tax-Questions-&-Answers/Interest,-Dividends,-Other-Types-of-Income/Life-Insurance-&-Disability-Insurance-Proceeds/Life-Insurance-&-Disability-Insurance-Proceeds

http://taxfoundation.org/blog/state-estate-and-inheritance-taxes-2014

Pete Blasi