Clients routinely inquire about whether their life insurance policy will bring an additional tax burden to their loved ones. In fact, how to avoid such a burden is an issue that I frequently discuss with our clients, regardless of whether their estate is worth five million or 50 million.
The question of “Is life insurance taxed,” is a rather complex one; there is no one-size-fits-all answer, particularly when you consider the many types of life insurance policies, the different forms of taxation, and the variances in tax law from state to state. What’s more, estate structure and overall estate value has a major impact on the equation. Therefore, tax liability is a very important issue that should be discussed with your estate planning and tax advisors. Generally, however, life insurance death benefits are most often income tax free, but not necessarily estate tax free.
So, how do you determine if your life insurance policy will lead to taxes? Well, you’ll need to determine what types of taxes may apply and then evaluate your situation to identify how you can minimize or even sidestep this problem, with the help of an experienced life insurance consultant.
How Is Life Insurance Taxed?
When exploring taxation issues, it’s important to make note of what type of tax or taxes may apply. There are many different forms of tax, including income taxes, estate taxes, and capital gains taxes, to name a few.
When it comes to life insurance benefits, income taxes and estate taxes are really the only forms of taxation that are typically applied. However, the matter of whether a policyholder’s beneficiaries will face any sort of tax liability will vary depending upon factors such as the ownership of the policy, the size of the estate, the structure of the estate, and even your state of residence.
Are There Income Taxes on Life Insurance Dividends?
In most cases, life insurance death benefits are not subject to an income tax, although there are some exceptions. So for this reason, it’s important to have a discussion with an experienced and trusted life insurance advisor, and a tax professional if needed. This would be someone who understands the tax laws at the federal level and in your state (as well as in the beneficiary’s state, if it’s different from your own).
In most cases, life insurance death benefits are not subject to an income tax, although there are some exceptions.
Some individuals have concerns over income tax for cases when the policyholder opts to cash in a whole life insurance policy, but these dividends are typically considered a return of your premium. If the amount a person receives is equal to or less than the amount that was paid into the policy, then it’s unlikely that it would be subject to a federal income tax. There are a number of state-specific income tax laws, so again, it’s wise to consult a tax advisor to learn more about any possible state income tax liability.
Estate Taxes and Life Insurance Death Benefits
While life insurance proceeds are most often income tax free, in some cases, a policyholder’s beneficiaries may face federal and even state-based estate taxes on a life insurance policy’s death benefits. There are a few variables at play, including:
- Value: The sum of the death benefits and the value of the estate as a whole
- Policy ownership type: The type or structure of the life insurance policy ownership and its recipients (which could be an individual, a trust, etc.)
- Structure: The structure of the estate and any trusts named as beneficiaries
- Location: Laws differ from state to state, while federal laws apply nationwide
Estate tax liability in 2021 typically starts at $11.7 million for an individual and $23.4 million in the case of a couple. Therefore, if the estate (with death benefits included) has a value that’s less than either of those amounts, federal estate taxes may not be a major concern.
Some states may have estate taxation laws that differ from the federal guidelines, so it’s best to consult with a tax and financial consultant to discuss what tax liabilities are likely to apply to your unique situation.
How Do You Account for Taxes During the Estate Planning Process?
Simply being aware of the potential for taxation can go a long way during the estate planning process. Fortunately, it is possible to avoid or minimize the tax burden by taking a highly strategic approach to estate planning. An experienced life insurance professional can work with you to choose the right type of life insurance coverage. It may also be possible to structure your estate in a manner that lessens or eliminates any tax liability altogether. Through this strategic planning process, you may even discover that your estate is not large enough to qualify for estate taxation.
It may also be possible to structure your estate in a manner that lessens or eliminates any tax liability altogether.
A seasoned financial, estate planning, and tax consultant can work with you to determine the amount of any unavoidable tax liabilities. In that way, you can take action to help offset any liability, such as purchasing additional life insurance coverage, restructuring your estate, or putting aside additional funds to cover taxes. This can provide you with tremendous peace of mind as you proceed into your golden years, knowing that your loved ones will remain in a good financial position even after you’re gone.
Howard Kaye Insurance has been advising clients on annuities, estate planning, and life insurance for more than 55 years. We have developed strategies specifically for estate planning using annuities and life insurance to maximize wealth transfer. Contact a Howard Kaye advisor at 800-DIE-RICH to discuss strategies for leveraging your tax-deferred annuities as part of your estate plan.
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Image 2 Courtesy of LotteMeijer.
