Pay Tax on a Life Policy Payout?

One of the advantages of life insurance payouts is that they are that tax-free, right? Well, that’s often true, yet not always. It pays to know when the taxman can take a bite of your benefit.

Your tax liability for life insurance policy payouts varies widely based on your situation. Let’s look into the basic rules and a few specific cases.

Official definition. First, you need to know whether the life policy meets Internal Revenue Service qualifications as an insurance policy in terms of such details as value and premiums.

The IRS considers the type of policy, date of issue, amount of the death benefit and premiums paid. IRS definitions ensure that an insurance policy isn't actually an investment vehicle. Many policies are really investment vehicles and sometimes taxed differently on distribution to a beneficiary.

Check with your financial planner to determine the type of plan providing the payout, such as term, universal or a return of premium policy where you reclaim the money you paid in premiums if you outlive the policy’s term.

Pre- or after-tax dollars? For a qualified life insurance policy, the designated beneficiary most likely receives the payout as a tax-free amount. For example, the beneficiary of your $500,000 life policy generally pays no state or federal income tax on the payout.

The tax treatment starts to get a little complicated when you pay for policies in pre-tax dollars. For the most basic life policies, you pay premiums with after-tax dollars. But if you contribute pre-tax dollars to some life insurance policies, it may affect the taxable status for payouts to the beneficiary.

Estate taxes. While you may not have to pay state or federal income taxes on your life insurance payout, you may encounter estate taxes on a benefit that exceeds a certain amount.

Ownership of the policy makes a difference. If the policy’s owner dies and the payout exceeds $5.34 million (up $90,000 from 2013 limits) beneficiaries must pony up the state’s estate tax on the payout. If the beneficiaries own the policy, the payout escapes estate tax.

Spouses can transfer assets to each other tax-free; most others feel the grip of the tax man. Let’s say you buy a $1 million policy and name your son as the beneficiary. When you die, the life policy goes into your taxable estate. If the total amount of that estate exceeds the then-current state or federal estate tax exemption, you son pays a tax bill on your policy.

Annuity payments. Sometimes life payouts come with an annuity option. While the tax exclusion applies for the face value of the policy, the beneficiary may pay tax on the interest earned above that face value.

The insurance company distributing the payments provides details on periodic payments and interest applied. Expect a form at the end of each year documenting the taxable amount based on the interest earned and distributed.

In general, life insurance policies are tax-free to beneficiaries. But that doesn’t mean all the time. If you prepare your own taxes, check with an accountant if you receive a life insurance payout and review your current life policy with a professional to make sure your beneficiaries benefit in terms of tax savings.

Better yet, contact a financial planner and certified public accountant for tax advice regarding any life insurance payout.

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Jeff Rose, CFP, is the founder of Alliance Wealth Management in Carbondale, Ill., and also is the founder of the website Good Financial Cents and Life Insurance by Jeff.

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