Tax Season 2020: What You Should Know About Life Insurance and Taxability

2
2
Corporations COVID-19 cash value unemployment benefits cash cushion Top 10 companies with largest cash reserves in the world
pasja1000 / Pixabay

During tax season each year, we often spend time talking about going through old receipts, and tax bills, and refunds, and tax credits, and deductions… Frequently, life insurance isn’t part of that conversation.

But as someone who works around life insurance every day, I think this can be an important part of the conversation at this time of year.

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Q4 2019 hedge fund letters, conferences and more

Death Benefit

At the most basic level, life insurance proceeds are generally not taxed, which is good news if you are the beneficiary of someone’s life insurance policy or if you have received a payout (known as the “death benefit”).

Top value fund managers are ready for the small cap bear market to be done

InvestorsDuring the bull market, small caps haven't been performing well, but some believe that could be about to change. Breach Inlet Founder and Portfolio Manager Chris Colvin and Gradient Investments President Michael Binger both expect small caps to take off. Q1 2020 hedge fund letters, conferences and more However, not everyone is convinced. BTIG strategist Read More

Often, when people are deciding whether or not to apply for life insurance to help protect their loved ones, they speak in terms of income. That’s because life insurance is sometimes considered “income replacement.” For example, when determining how much life insurance you should apply for, many experts suggest choosing an amount that’s five to ten times your annual income. That way, if you were no longer around, the money would go to the people you designate as your life insurance beneficiaries—generally, this is probably the people who depend on you financially.

They could use this money for a variety of things, such as paying back debts that you left behind, like a mortgage, credit card bills or student loans that someone else has cosigned on (meaning that they could still be on the hook for them). They could also use the money to pay for your funeral expenses, and for day-to-day living costs that you would have helped cover if you were still around.

How Much Coverage To Apply For?

Despite your income being part of the conversation when figuring out how much coverage to apply for, life insurance payouts aren’t actually income, at least as far as the IRS is concerned.

Similar to other types of insurance payouts, a life insurance company will send your beneficiaries a check if you incur “damages,” meaning that you, the insured person, were to pass away. That’s not so different from car insurance, in which the insurer would send you a check if your car got hit. As with car insurance, you’re not taxed on the money you get back. It isn’t income, after all, it’s a benefit you’ve already paid the insurance company for through your monthly premiums.

Still, there are some less-common cases in which life insurance could be taxable after all.

So, first and foremost, it’s important to note that the part of the payment that isn’t taxable is the death benefit. That’s the lump sum that the insurance would pay to your beneficiaries based on the face amount of your policy. For example, if you have a $1 million policy, then if and when the insurance company pays your beneficiary $1 million upon your death, that’s the death benefit. That’s not taxable.

But in some cases, that might not be the only money that you or your beneficiaries could collect from a given life insurance policy.

Exceptions To Term Life Insurance

First, let’s talk about some of these exceptions when it comes to term life insurance. Most of the time, beneficiaries receive their life insurance proceeds as a lump sum. But because it can be overwhelming to receive so much money at once, they may be able to receive the money in installments instead. You might actually be able to choose this as an option when you set up your life insurance policy. If the beneficiary does, in fact, receive payments as installments instead of a lump sum, then the remaining amount being held by the insurer will earn interest. The interest that they receive is taxable.

For what it’s worth, if the beneficiary got the payout as a lump sum and put it into a savings account that earned interest, then that interest would also be taxable as investment income. So it may actually not change too much when it comes to taxability if the beneficiary pays taxes accrued by the insurance company, all things equal. Regardless, it’s important to know what you’re getting into, tax-wise.

Also worth noting: If your life insurance policy is through the VA, then the interest isn’t taxable or reportable, either.

The Cash Value Component

Next, let’s talk about permanent, or whole, life insurance policies. The thing to pay attention to here with regard to taxability is that these policies generally have a "cash value" component that grows in value over time. So, yes, if you were to pass away then your beneficiary would receive the death benefit. But if you don’t pass away, you can borrow against or withdraw from your cash value amount, even while you’re still alive.

Your cash value grows as the insurer invests your contributions. You don’t pay taxes on the interest or earnings while this is all taking place. Instead, these earnings are tax-deferred. That means that if you take out distributions from your cash value while you’re still alive, you’ll pay taxes on that withdrawal if you start to reach into your earnings. In other words, if you have contributed $10,000 in monthly premiums and borrow less than that from your cash value, then you wouldn’t have to pay taxes. But if your cash value has grown to, say, $11,000 and you borrow that much, then you’d have to pay taxes on your earnings of $1,000.

In some cases, you might receive dividends from a whole life insurance policy, as well. These are usually not taxable, either. The exception is if you make more in dividends than what you paid that year in premiums. This is a real “if” case, because it’s unlikely: But if you paid $2,000 in monthly premiums in a certain year and received $2,500 in dividends, you’d pay taxes on the $500 over what you paid.

Seven-Pay Test

One other unusual way that you might be subject to taxes on life insurance is if you have a whole life policy and fail the “seven-pay test.” Permanent life insurance is a nice way to provide money to your survivors that’s tax free, since death benefits aren’t taxed. As a result, some people try to use life insurance as a tax avoidance strategy rather than primarily as a way to help protect the people who depend on their income.

A law called the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) actually limits how much you can put into a policy during the first seven years you own it, to maintain a reasonable difference between the death benefit your beneficiary would receive if you died and the cash value available for you to withdraw when you want it. After all, if you contributed a ton right away to boost your cash value, then is this really life insurance—or is it just a unique version of a savings account?

The limit on how much you can contribute toward the cash value depends on the size of your policy and how old you are. If you exceed that amount, your life insurance policy could be considered a modified endowment contract, or MEC, which has different tax implications. For example, with life insurance, you can withdraw your non-taxable portion of the cash value first. With an MEC, you need to withdraw your taxable portion first. The best way to avoid this is to adhere to the limits on your monthly premiums.

To reiterate, however: In most cases, the money received by your beneficiary if you were to pass away is not taxable. Even with whole life, the amount your beneficiary receives generally stays the same no matter when exactly you die or how much cash value you’ve accrued. With both term and whole life, this “death benefit” is not taxable.

Estate Taxes

Now let’s take a look at estate taxes: Most Americans don’t need to pay estate tax, since it’s only relevant for estates worth over $11.4 million, as of 2019 (and $22.8 million for married couples). For the most part, a life insurance death benefit isn’t considered part of your estate for estate tax purposes. In other words, still not taxable.

An exception might be if you left the death benefit not to an individual person but to your estate instead. In that case, because your estate would “inherit” your life insurance death benefit, then that money would count as part of the total value of the estate. If the value of your estate might exceed the limits for estate tax, then you might want to talk to an estate planning professional and an attorney about options like setting up a trust to keep your life insurance separate from the estate.

As with everything, it never hurts to talk to a professional accountant for expert advice on how to plan out your tax strategy. That said, for most Americans, life insurance shouldn’t be a big burden on their taxes.

In an often-frantic time of tax prep, that should be one fewer thing to worry about, at least.