You are not required by law to pay tax on life insurance proceeds. So, there is no need to be afraid in the first place. But things can switch up so fast if you don’t have an idea of how the whole thing plays out.
There are a few exceptions when you will be required to meet the requirements of taxability of life insurance proceeds. If you are looking to leave a bulk of money for your loved ones, it is better to prepare before time.
In this article, you will find out why the taxability of life insurance proceeds to a beneficiary will be required. You will also find out the best ways to avoid paying tax on the insurance payout.
Are Life Insurance Proceeds Ever Taxable? In Some Cases, Yes!
Generally, life insurance policyholders aren’t required to pay tax on the policy’s proceeds. Likewise, their beneficiaries wouldn’t be taxed. But some situations can call for taxability of life insurance proceeds on maturity.
Below are some of the reasons why your life insurance will be subject to taxation:
Interests are Taxed
The interests on life insurance policies will be taxed. The taxation comes into place when the beneficiaries fail to take out the death benefit in one lump sum.
In that case, the life insurance company would have to pay interest on the balance. It is through this that the interests become taxable.
Using Life Insurance Settlement Option is Taxable
Do you want to sell your life insurance policy before the end of the policy’s length or term? In that case, you may be taxed because life insurance settlement attracts such.
The process involves selling your life insurance policy to a third party who pays you to become the new policyholder.
The taxation is required because of the profits you make from either a capital gain being an overpayment of the policy’s cash value. It can also be charged if the income tax accruing to the cash value exceeds the basis of the policy.
Life Insurance Surrender is Taxed
This is the shorter route to selling or giving up your life insurance policy. It involves giving up or “surrendering” the policy, therefore, canceling it.
In turn, your life insurance policy provider cancels the policy and pays you the cash value minus the fees charged for surrendering the policy.
However, you will only be taxed if the payout is more than what you paid as premiums during the existence of the policy.
How to Skip Taxability of Life Insurance Benefits
Now, let us talk about some of the efforts you can make to avoid paying tax for a life insurance payout.
1. Use Irrevocable Life Insurance Trust to Avoid Estate Taxes
Irrevocable Life Insurance Trust (ILIT) is one of the effective ways to avoid the taxability of life insurance proceeds. The process involves transferring your ownership of the life insurance policy to the ILIT.
The idea is to hold the life insurance policy “in trust” without you being active. To that end, you want to keep to most of the conditions of using an ILIT.
Here are some of the ILIT conditions that should help you avoid being eligible for taxability of life insurance:
Non-Trustee
By transferring the life insurance policy to the ILIT, you need to relinquish being a trustee of the estate. That is one of the best ways to avoid paying tax on income.
Zero Ownership
Since you have transferred the policy to the trust, you are no longer legally recognized as the owner.
However, there are a few exceptions where you may exercise some legal rights. For example, you may be able to name the trust’s beneficiary. This privilege is mostly granted if you have children that would become beneficiaries of the death benefit.
In that case, you will be allowed to name a trusted family member who will be the trustee to oversee the handling of the money on behalf of your kids.
2. Do not Withdraw more than the Cash Value
This is common sense and you should use it to avoid the taxability that comes with life insurance proceeds.
What this means is that you should avoid withdrawing more than the cash value. That way, you keep within the “basis,” being the total amount of money paid as premiums over time.
3. Transfer Your Life Insurance Policy to Someone Else
Don’t want to have your life insurance policy taxed? Maybe, you don’t want your estate to be taxed either. A better way to avoid the tax consequences of life insurance proceeds is to transfer them to someone else.
In this case, you are mandating someone else to become the new policyholder. While this is a smart way to avoid life insurance taxation, you have to be careful how you go about it.
Here are some tips to help you with the transfer of your current life insurance policy to someone else:
Choose a Trusted Entity
Who do you trust the most to handle your life insurance policy? It could be your spouse or relative. Whoever it is, the person must be competent and reliable.
Inform Your Life Insurance Company
Picking a competent person to become the new life insurance policyholder is the first step. The next step is to contact your life insurer and let the company know of the changes.
In addition, you want to request the proper assignments or transfer of ownership forms. That way, the person you picked will be listed as the new policyholder.
Obtain Written Confirmation of Life Insurance Transfer
The next step is to obtain written confirmation of the life insurance policy transfer. Your life insurance company should issue you with that.
Conclusion: Life Insurance Proceeds are Taxable in Some Cases
Although you aren’t required to pay tax on life insurance proceeds, some situations can call for it. As a beneficiary, you want to be careful how you go about claiming the death benefit. The best strategy is to withdraw the death benefit as one lump sum. That way, you avoid the interest rate that the insurer will have to pay to service the remaining balance.
On your part as the policyholder, you want to avoid naming an estate as the beneficiary because it can be taxed.
However, you may be able to get someone else to take the policy even before its expiration. Just don’t take more than the cash value so you don’t attract the taxman. In all, consult your life insurer to be certain of the taxable portion of life insurance proceeds. The information should help you decide on the best way to avoid taxation of the death benefit.
