Do You Have to Pay Taxes on Life Insurance

Do You Have to Pay Taxes on Life Insurance?

Will Your Life Insurance Payout Be Taxed?

The money paid to the named beneficiary of a life insurance policy is not taxable in most cases.

In some circumstances, life insurance proceeds can be taxable. In this blog post, we will explain when a life insurance death benefit could be considered taxable income and what steps someone can take to reduce the likelihood of exposing the beneficiary of your life insurance policy to unnecessary taxes.

Interest Income Is Taxable

Life insurance beneficiaries are not required to receive the death benefit payment in a lump sum. Insurance companies offer several options as to how a beneficiary wishes to receive the funds due to them. In some cases, beneficiaries choose to have the insurance company hold the funds for an extended time before issuing payment.

During this period of delayed payout, interest accrues on the funds. When the payment is ultimately made to the beneficiary, the interest income on the original death benefit will be taxable income.

When a life insurance policy holder either fails to name a beneficiary or names their own estate as the beneficiary of the policy, the heirs to the estate may incur an estate tax obligation.

Benefit Paid as Annuity

Some beneficiaries choose to convert the death benefit amount into an annuity and to receive regular payments over the course of their life. In these cases, the beneficiary is purchasing the annuity with non-taxable funds from the death benefit. The insurance company will make equal payments to the beneficiary/annuitant based on their life expectancy.

For example, if the death benefit was $250,000 and the beneficiary/annuitant has a life expectancy of 10 years, then the annuity would pay them $25,000 each year for 10 years. None of those payments would be taxable. But if they live longer than 10 years, the payments they continue to receive exceed the amount of the non-taxable death benefit. The money received in excess of the amount of the death benefit is fully taxable.

New York Estate Taxes

When a life insurance policy holder either fails to name a beneficiary or names their own estate as the beneficiary of the policy, the heirs to the estate may incur an estate tax obligation. Though there is no inheritance tax in New York, an estate that exceeds the value of the New York estate tax exemption amount by more than 5% can suffer a disproportionately high tax bill.

The dollar value of a life insurance death benefit can be modest or very substantial. With a New York estate tax exclusion currently set at $6,110,000, adding a $4 million or $5 million death benefit to a large estate could boost the estate’s value far beyond the NY exemption level. Since 5% above the NY exception is $6,405,000, an estate with a value exceeding that amount falls off what is called “the New York estate tax cliff.”

Unlike states that tax only on the portion of the estate that exceeds the value of the exemption, New York’s estate tax law taxes the entire estate value if the estate’s value is more than 5% above the level of the exemption.

The federal estate tax exemption amount is currently relatively high, $12.06 million, a level high enough not to concern most families. However, unless Congress takes action to extend the elevated exemption level, the federal exemption will revert to a level less than half its current level in 2026.

Irrevocable Life Insurance Trust

One of the most reliable means by which someone can prevent unnecessary tax liability for life insurance death benefits when one chooses not to name a direct beneficiary is to create an Irrevocable Life Insurance Trust (ILIT).

The IRS may consider a life insurance policy’s death benefit to be an estate asset if the policy owner retains some incidence of ownership in the policy at the time of their death. To avoid that result, an ILIT is irrevocable, preventing the trust donor or settlor from exercising any control or ownership over the trust once it is created and funded.

The ILIT cannot be rescinded, modified, or amended.

The benefits provided by the ILIT over naming a direct beneficiary or including the death benefit in the decedent’s estate include favorable tax treatment, the protection of the trust assets from the creditors of the intended beneficiary, and the protection of the trust assets from a beneficiary who might otherwise quickly squander the assets.

To ensure they have surrendered all control over the trust assets, the ILIT donor cannot be named as trustee. If the trust donor who created the trust retains any “incidence of ownership” over the trust, then, as noted above, the trust assets can be deemed an estate asset, risking estate tax obligations for your heirs, and losing the ILIT’s spendthrift benefits.

An ILIT is also of value if the intended beneficiaries are minors. Naming a trusted, responsible person to act as trustee ensures that the assets are properly managed for the benefit of the minor beneficiaries. The selection of the trustee is a “one-time-only” opportunity; once named, the creator of the trust cannot change the trustee or modify any of the trust’s terms.

Life Insurance As Part of Your Comprehensive Estate Plan

Ely J. Rosenzveig & Associates has extensive experience representing clients in estate, trust, and tax planning matters. Our law firm focuses on structuring trust and estate plans that achieve each client’s goals and that eliminate or minimize unnecessary tax exposure.

Understanding your personal and family circumstances enables us to create the individualized trust and estate plans that serve your needs and ensure that your financial assets are protected for your heirs and beneficiaries precisely as you intend.

Part of your estate plan may include life insurance as one component. Any single element of a skillfully drafted estate plan is integrated into the overall plan to maximize the security of your family and to insulate your estate from avoidable expenses.

If you would like to learn what Ely J. Rosenzveig & Associates can do for you and your family’s estate plan, contact our office today. We welcome your questions.

Contact Ely J. Rosenzveig & Associates
Call 1.914.816.2900 or email us at: [email protected]

Ely J Rosenzveig
Ely Rosenzveig

Ely J. Rosenzveig practices principally in the fields of elder law, trusts & estates, tax planning, employment law, and mediation. He has extensive experience in federal and New York State tax law, and has successfully represented a wide range of clients on FBAR & FATCA compliance issues. Ely also practices employment law, with a particular emphasis on age and disability discrimination, negotiating compensation agreements, and severance issues. With his extensive background in the law, his experience as a congregational rabbi, and his specialized training in Mediation at Harvard Law School, Ely is also available as a professional mediator to help facilitate optimal solutions in matters ranging from family and estate disputes to multi-party commercial issues.

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