Laura Berry is a former State Farm insurance producer and insurance expert.

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Dan Walker graduated with a BS in Administrative Management in 2005 and has been working in his family’s insurance agency, FCI Agency, for 15 years. He is licensed as an agent to write property and casualty insurance, including home, auto, umbrella, and dwelling fire insurance. He’s also been featured on sites like Reviews.com.

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Reviewed by Daniel Walker
Licensed Car Insurance Agent

UPDATED: Jan 13, 2017

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Don't miss these facts...

  • There are instances when life insurance proceeds are taxable
  • There are instances when life insurance proceeds are not taxable
  • How a life insurance policy is set up from the outset can determine taxability
  • Elicit professional assistance when arranging the details of your life insurance so the best possible outcome is experienced

Life insurance proceeds are, in most instances, not taxable for Federal Income Tax purposes to a named beneficiary.

This ruling is in keeping with one of the major purposes of life insurance coverage; that is to protect widows and orphans from the hardships of the early death of a breadwinner.

The law does not differentiate from the type of life insurance in force, whether it is term life insurance or permanent. It just addresses life insurance proceeds from any source.

The IRS specifically states that proceeds from life insurance are not taxable to a named beneficiary for income tax purposes and that these proceeds do not even have to be reported to the IRS.

The instance where life insurance is purchased and owned by an individual and the spouse is the beneficiary is far and away the most common use of life insurance, and in nearly all of the cases, the proceeds are not taxable under the IRS ruling.

Or, depending on who is deemed to have made the gift, could be named as the person to pay the gift tax.

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Are There Instances When the Proceeds From Life Insurance Are Taxable?

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There are situations where the death benefit from life insurance proceeds can be taxable to a beneficiary.

The following examples illustrate these various instances:

Transfer For Value

A transfer for value occurs when a life insurance policy is transferred to another party for valuable consideration, whether it be for money of for property, then a portion of the death proceeds can be taxable as ordinary income to the beneficiary.

A general rule of thumb on the taxability of proceeds states that the amount of money or property transferred plus any future premiums will be received tax-free, but any difference over and above that amount will be taxable.

Transfer for value transactions can be fairly complex, and it is advised that individuals or business entities considering such transactions receive advice from competent tax advisors before entering into such transactions.

If A Life Insurance Policy Is Assigned or Transferred

If a policy owner assigns a life insurance that he or she owns prior to three years of his or her death, the proceeds could still be included in the gross estate for estate or gift tax purposes. Whether the policy is assigned or given as an outright gift, the results could be the same.

The transfer of life insurance to a third party is usually done to keep the proceeds of the policy out of the estate at the death of the insured.

Most states require inclusion if the deceased had any incidents of ownership in the policy, such as being the outright owner, he or she paid the premiums or had the right to name the beneficiary.

If the policy is assigned or transferred, and more than the three years passes, then taxation as gift or estate tax is avoided.

If a Life Insurance Policy is Surrendered or Cashed In

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Permanent life insurance such as whole life, universal life, indexed universal life, and variable life all accumulate cash values, dividends, and interest in various combinations and formulas.

If a permanent policy is surrendered, and the amount of the cash value is in excess of the amount of premiums paid into the policy, that excess is taxable as ordinary income.

If Policy Ownership Provisions are Not Correctly Assigned

Usually, the ownership of life insurance policies is fairly straightforward and very logical. The insured is the owner, and the beneficiary is the beneficiary.

In some cases, the beneficiary might be the owner if the insured is or becomes incompetent or incapable of managing the premiums of the policy.

If the ownership relationship is viewed as a three-point triangle, consisting of the policy owner, the insured and the beneficiary.

The solution to a problem that could develop is to keep at least two points of the triangle as the same person. If there are different people or entities at each of the points, then the death benefit could become a taxable gift to the beneficiary.

The consequences of improper ownership stem from the Goodman v. Commissioner of the Internal Revenue Service where the IRS determined that the premiums of a life insurance policy were gifts from one party to another, and thus the beneficiary was taxed on the proceeds of the life insurance as a gift tax.

Others could be taxed, depending upon who was deemed to have been giving the gift. Remember the triangle and have only two people be the owner, beneficiary or the insured.

Section 79

Under Section 79 of the IRS tax code, it is stated that group term life insurance that is issued to employees of $50,000 or under is not taxable to the employee as far as the premiums are concerned.

Any premium amount that is over the $50,000 is taxable to the employee.

An example would be an employee who receives $40,000 of coverage from the employer, and there are no tax consequences there. The employee is eligible under the benefit plan to receive an additional $100,000 of optional life insurance coverage.

The cost for $10,000 can be excluded from the employee’s income, but the cost of the remaining $90,000 of coverage would be taxable to the employee and subject to payroll taxes.

The Annuity Rule

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Under the IRS Code Section 525, payouts under annuities are fairly straight forward. If the annuity had been purchased with pre-tax dollars, then the proceeds are taxable from the very beginning of withdrawals and from then on.

If the annuity had been purchased with after-tax dollars, then the IRS applies a formula that taxes interest and principle on a sliding scale.

The advantage of the annuity rule for after-tax dollar purchases of annuities is that the taxation is spread out over the life of the payout. This gives retirees a better tax treatment and helps them to benefit from a better tax treatment.

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General Principles Of Life Insurance Taxation

It is important to remember that the traditional way of setting up a life insurance policy is to make the insured the owner of the policy, and the beneficiary is the beneficiary.

The proceeds of the life insurance policy are received by the beneficiary free of income tax, and the inside buildup of cash in the policy, if it is a permanent policy is tax-deferred.

If there are other arrangements made by an insurance agent or adviser, you should ask that the tax ramifications be explained to you in detail.

If that person cannot explain the details to you adequately, do not hesitate to go to someone who can.

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