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Life Insurance Benefits: Exceptions to Tax Exemption

Life Insurance Benefits and TaxabilityFor most people, the concept of life insurance is about ensuring their loved ones are financially secure in the event of their unexpected demise. However, there’s more to life insurance than just buying cover for death benefits.

This article will cover the taxability of life insurance benefits, assistance in estate tax planning, and the benefits of having life insurance.

Definition of life insurance as an Asset

Life insurance, like other assets, is considered property and is legally eligible for sale, assignment, and transfer to others. Life insurance benefits, whether paid in lump sum or incremental payouts, are treated as taxable income, although some exemptions may apply.

One notable exemption is the death benefit, which isn’t taxed if paid in a lump sum.

Lump Sum Death Benefits and Tax Exemption

The Internal Revenue Service (IRS) rules define lump-sum death benefits as payment made to beneficiaries of a definitive amount after the life insured dies. Such payments are excluded from the beneficiary’s income tax.

The death benefit doesn’t have to go to the estate but can be payable directly to the named irrevocable beneficiary.

Incremental Payouts and Interest Earned

Life insurance benefits paid in installments may be subject to income tax. The increment is treated as the interest paid on the death benefit, which is taxable.

Whether the payouts accumulate and earn interest depend on the policy conditions and the manner of payout. If the death benefit bears an interest and accumulates, the amount that represents interest is taxed as ordinary income.

The principal amount, which is considered an investment in the contract, isn’t taxed.

Estate Tax Threshold and Avoiding Tax

The estate tax threshold is the minimum value of an estate above which estate taxes are levied. As of 2021, the federal estate tax threshold is $11.7 million for individual taxpayers, and $23.4 million for couples filing jointly.

Individual states have their own estate tax thresholds – certain states such as New York and Massachusetts have a lower threshold. Estate tax planning can help the insured avoid or reduce estate taxes.

This is done by implementing specific strategies such as credit shelter trusts (CST), Qualified Personal Residence Trust (QPRT), and others.

Generation-Skipping Transfer Tax

The generation-skipping transfer tax (GSTT) is a secondary tax levied on assets transferred to beneficiaries who are two or more generations younger than the transferor. It applies to trusts, estates, and life insurance policies transferred directly to a person who is two or more generations younger than the transferor of the tax.

To avoid the GSTT, you can work with professional advisors who understand the complex rules and can advise on structuring and executing trades in a tax-efficient way.

Gift Tax and Annual Exclusion

The gift tax is applied when property or assets are given to someone without receiving anything of equal monetary value in return. As of 2012, the annual gift tax exclusion was $14,000 per person.

However, under the 2020 CARES Act, the gift tax exclusion has been increased to $15,000 per donor/recipient. This increase will remain in place until 2025 unless changed by Congress.

By gifting life insurance policies, the donor relinquishes any right to the policy, and the recipient assumes ownership of the policy and all risks associated with it.

Cash Value Policy and Taxable Withdrawals

A cash-value policy, also called a permanent life policy, is a policy that offers both protection and an investment component. The investment component can accumulate over time and be withdrawn once the policy has accumulated enough cash value.

However, any withdrawals made are treated as taxable income. The amount taxed is the difference between the cash value of the policy and the premiums paid to date.

Group Life Insurance and Imputed Income

Group life insurance is offered by employers as an employee benefit. This benefit is generally offered to every employee regardless of their health status.

The employer pays the premiums for the policy cover, but the value of the policy is taxable to the employee. If an employee’s coverage exceeds the threshold amount of $50,000, the employer can account for it as imputed income.

The imputed income is the amount of premium paid by the employer less the first $50,000 of coverage offered to the employee. This income is included in the employee’s creditable compensation and is subject to withholding taxes.

Benefits of Life Insurance

Life insurance offers financial security to loved ones – providing a lump-sum death benefit that can be used to offset costs such as funeral expenses, and providing ongoing support for survivors. Life insurance also replaces lost income caused by the untimely death of a breadwinner.

This allows your dependents to maintain their lifestyle and financial security. Lastly, purchasing life insurance can also be a future asset.

Over time, permanent policies accumulate a cash value that can be borrowed against or withdrawn to provide a financial cushion later in life.

Conclusion

In conclusion, life insurance isn’t just an asset for death benefits – it can also be an essential tool for financial planning. Understanding the taxability of life insurance benefits, estate tax planning, and the benefits of having life insurance can help you make informed choices about your financial future.

Work with a qualified financial advisor to navigate the complex financial rules that apply to life insurance. Exceptions to Tax Exemption for Life InsuranceLife insurance provides financial security to dependents or beneficiaries by paying out a lump sum or providing incremental payouts according to the policy terms.

Life insurance benefits are, in most cases, tax-free, although there are some exceptions. This article will discuss the exceptions to tax exemption for life insurance in detail.

Estate Tax and Exceeding the Threshold

The federal estate tax applies to estates exceeding certain thresholds. As of 2021, the estate tax threshold is $11.7 million for individual taxpayers and $23.4 million for married couples filing jointly.

Any amount exceeding the estate tax threshold is subject to a 40% tax. Life insurance benefits payable to beneficiaries are tax-free, but the death benefit is included in the taxable estate, which can push the estate value above the threshold, thus bringing the estate tax into play.

To avoid estate tax, some people can incorporate the benefits into an Irrevocable Life Insurance Trust (ILIT) or buy an insurance policy in trust. The trustees own the policies, and the beneficiaries receive the death benefit tax-free.

Generation-Skipping Transfer Tax

The generation-skipping transfer tax (GSTT) is a tax on assets transferred to people two or more generations younger than the transferor, such as a grandchild or a great-grandchild. The tax applies in addition to any applicable estate or gift tax.

The tax rate for the GSTT is 40%, the same as the estate tax. Life insurance benefits transferred directly to a person two or more generations younger than the policy owner are subject to GSTT.

The GSTT’s threshold exemption in 2021 is $11.7 million while the maximum tax rate is at 40%. One way to avoid the GSTT is to transfer interests to an Irrevocable Trust for Planned Giving according to the

Generation-Skipping Transfer Tax Exemption Rule. This approach allows for a tax-free transfer of assets within the trust after the 90th year of the trust in favor of subsequent generations with the level of GSTT exemption that applies as of that year.

Gift Tax and Lifetime Exemption Threshold

The gift tax is a tax levied when a donor gift of money or property is given without receiving something of equal value in return. As of 2021, the annual exclusion of $15,000 applies per donee, meaning a taxpayer could gift up to $15,000 to each of their donees without incurring a gift tax or an obligation to file a gift tax return.

The lifetime exemption is $11.7 million and applies in addition to the annual exclusion. The lifetime exclusion is the total amount that a taxpayer can give away during their lifetime without being subject to the gift tax.

Gifting of life insurance policies is a common estate planning strategy that can remove the policy’s value from the donor’s estate. However, if the value of gifts given over the donor’s lifetime exceeds the lifetime exemption threshold of $11.7 million, the donor becomes liable for gift tax.

Taxation of Cash Value Policies

Cash value policies are also known as permanent life insurance policies, and they build up value over time. Before the policy is surrendered or matures, the policyholder can take out a loan or a withdrawal against the policy’s cash value.

The policy’s ownership structure and the amount of cash value withdrawn determine if there is a tax on cash value withdrawals. In general, withdrawals from life insurance policies that are above the policyholder’s premium payments will be taxed as ordinary income.

The policyholder pays tax on the difference between the amount withdrawn and the total premiums paid to date. If there’s a loan outstanding, the amount borrowed is tax-free.

However, if the policy is surrendered, the total cash value may be taxable.

Workplace Group Life Insurance Exemption

Employers often offer group life insurance policies as an employee benefit, and premiums are often taxable compensation. However, if the group policy falls under IRC Section 79, some or all of the premium value could be excluded from the employee’s taxable income.

The exclusion applies to the first $50,000 of coverage provided by the employer. The employee could face imputed income if the employer provides $50,000 or more in group life insurance coverage.

Imputed income is the difference between the value of the coverage exceeding $50,000 and the total premium paid by the employer. Imputed income is taxable compensation for the employee.

Conclusion

Life insurance is an essential part of financial planning, and the tax benefits associated with life insurance are valuable. However, understanding the exceptions to tax exemption should be a consideration in any financial plan.

Excessive exposure to estate tax, the gift tax, GSTT, and workplace group life insurance premiums can have an impact on the payout of life insurance benefits. The use of trusts, changing ownership of the policies, and other financial strategies can help reduce or eliminate the tax liability associated with a life insurance payout.

Overall, gaining an understanding of how taxes are imposed on life insurance can help you make informed decisions about how you set up your policy and your estate plans. It is best to consult with a financial advisor or attorney with expertise in estate planning and insurance to help navigate these topics.

In conclusion, life insurance benefits are typically tax-free, but there are exceptions that people should consider as part of their estate and financial planning. The exceptions to tax exemption for life insurance include estate tax, GSTT, gift tax, taxation of cash value policies, and workplace group life insurance premiums.

Understanding these exceptions is essential in developing a financial plan that mitigates tax liability on life insurance payouts. Thus, it is crucial to consult with a financial advisor or attorney with expertise in estate planning and insurance to help navigate these complex tax topics.

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