Taxable Life Insurance Benefits
Life insurance death benefits are usually a lump sum of money paid to beneficiaries that is tax-free. Sometimes there are circumstances when the death benefits are subject to taxes. For instance, when they are paid in installments or exceed a certain threshold.
Life insurance is a great way to ensure your beneficiaries are well looked after in the event of death. It ensures there is money for college, mortgage and other necessities. Other large amounts of money, like lottery winnings, will be taxed. So are life insurance benefits taxable? Not usually.
Life Insurance and The Tax Code
This article is meant to clarify what is taxable and what isn’t when it comes to life insurance. There are specific sections of the U.S. tax code that determine that. These code sections are guidelines for tax insurance rules.
Tax code sections to be familiar with:
- U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter B, Part III, § 101 – Certain death benefits — This section discusses benefits received by “reason of death.” It sets the groundwork for the circumstances under which someone receives life insurance benefits, including accelerated death benefits — benefits from an insured who hasn’t died but is terminally ill.
- U.S. Code, Title 26, Subtitle F, Chapter 79, § 7702 – Life insurance contract defined — In short, this section answers the question, “what is life insurance?”
- U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter L, Part I, Subpart B, § 803 – Life insurance gross income — This section notes that dividends are not taxable — something that’s important in permanent cash-value life insurance policies.
It’s not essential for a policyholder to know all about the U.S. tax codes; an estate planner can help clear up any misunderstanding you may have and help determine what is taxable and what isn’t.
Types of taxes:
Generally a life insurance death benefit is not taxed, therefore income tax does not apply.
However, there are 3 kinds of taxes any beneficiary should be aware of and these are gift taxes, estate taxes, and generation-skipping transfer tax.
- Estate tax — The federal estate tax applies to high-value estates. As of 2018, the current estate tax threshold is $10 million. Any amount of your estate over the estate tax threshold is subject to taxation. In addition to the federal estate tax, states can also have their own estate or inheritance tax. Estate taxes are set against the estate, while an inheritance tax is levied on transferred assets.
- Gift tax — A federal tax on assets given as gifts. It’s in place to prevent people from avoiding taxes by “gifting” money rather than it being included in an estate. This most often comes into play when the policyholder is still alive and transfers a policy to a beneficiary. There is a lifetime exemption that is the same as the estate tax as well as an annual exemption ($15,000 as of 2018).
- Generation-skipping transfer tax — As the name implies, this applies to assets that skip a generation (for instance, a grandparent leaving property to a grandchild). It has the same exemption limits as the estate tax.
These taxes will not apply in every situation, and most people will be exempt from them due to their high limits. But they’re important to keep in mind, as they’re each a valuable component of estate planning.