I am trying to find a source for why they always say life insurance proceeds are generally tax free. I can't remember the circumstances when someone dies their life insurance does not qualify for the tax free treatment. Hopefully the smarter people here can help me.
Are Life insurance payouts ever taxable for income tax
- Thread starter walthamny
- Start date
- 11,266
There is a differentiation between income tax-free and estate tax-free.
Life insurance proceeds are income tax-free, but not necessarily estate tax-free. That's why ILITs were created - an irrevocable trust to remove the life insurance from the taxable estate. The ILIT collects the proceeds outside of the taxable estate.
Life insurance proceeds can be subject to income taxation IF:
- The policy was held in a qualified retirement plan and the proceeds are withdrawn.
- The policy premiums was deducted from a company's taxes on a key man or similar policy... then the proceeds would be taxable income to the company. At least that's the warning I give to business owners who want to deduct the premiums... and to consult their accountant.
These links may be helpful:
How are life insurance proceeds taxed? | Investopedia
Life Insurance & Disability Insurance Proceeds | Internal Revenue Service
Life insurance proceeds are income tax-free, but not necessarily estate tax-free. That's why ILITs were created - an irrevocable trust to remove the life insurance from the taxable estate. The ILIT collects the proceeds outside of the taxable estate.
Life insurance proceeds can be subject to income taxation IF:
- The policy was held in a qualified retirement plan and the proceeds are withdrawn.
- The policy premiums was deducted from a company's taxes on a key man or similar policy... then the proceeds would be taxable income to the company. At least that's the warning I give to business owners who want to deduct the premiums... and to consult their accountant.
These links may be helpful:
How are life insurance proceeds taxed? | Investopedia
Life Insurance & Disability Insurance Proceeds | Internal Revenue Service
- 15,041
Don't forget the Goodman Triangle too.
- 11,266
I never heard of that... but I'm reading about it now. Makes logical sense.
- 15,041
Really, as big a student of life insurance as you are, and you haven't heard of the Goodman Triangle? I must say, I am surprised.
I don't know how often life insurance ends up taxable due to this. I suspect not often as agents should catch it and I doubt the IRS investigates this at all, but it is an easy trap to fall into and make life insurance taxable (income tax).
- 11,266
I'm surprised too! There's not much that I haven't at least HEARD about... but this one was new to me.
Goodman triangle triggers a gift tax, not income tax.
- 15,041
Gotcha. I just took away from it to avoid it. I forgot most of the details.
Normally, it is a business arrangement (set up poorly) that can trigger income taxation on a death benefit.
- 4,549
In addition to the Goodman triangle, I believe capital gains tax can be owed on policies that were purchased as an investment, such as viatical/life settlements/STOLI.
So, if I sell my $100k policy with $30k CV to investors & they pay another $15k in premiums, I have 45k basis in the contract. I believe a 55k capital gain would be reported at time of $100k death benefit payout. If a term policy, I thought I had previously read the entire face amount would be a capital gain as term has no CV & is entirely cost of insurance which reduces your cost basis in the capital gain calculation.
Unless you are selling life settlements, this isn't something you should face much with clients as there are not too many private buyers of life settlements
So, if I sell my $100k policy with $30k CV to investors & they pay another $15k in premiums, I have 45k basis in the contract. I believe a 55k capital gain would be reported at time of $100k death benefit payout. If a term policy, I thought I had previously read the entire face amount would be a capital gain as term has no CV & is entirely cost of insurance which reduces your cost basis in the capital gain calculation.
Unless you are selling life settlements, this isn't something you should face much with clients as there are not too many private buyers of life settlements
