Taxing life insurance benefits is dependent on several factors.

You have people who depend on your income.

Perhaps this is your spouse only.

Maybe you also have children.

Life insurance can be useful in providing financial protection for your loved ones if you were to die.

According to a recent MoneyWise article titled “Are Life Insurance Benefits Taxable?,” you may need to take into account how taxes could impact the life insurance benefits for your heirs.

Taxes may take a cut from your life insurance benefits.

In most instances, life insurance benefits can pass without taxes.

What are the exceptions?

You have a high-value estate.

At this time, the federal estate tax exemption is $11.58 million per person (or twice that for a married couple).

If your estate is greater than this amount, you will owe between 18 percent to 40 percent of the value above this amount to the IRS.

If you have life insurance and a high-valued estate, your life insurance benefits could be taxed.

With an irrevocable living trust, you may be able to protect your assets from the IRS.

Your state of residence has an inheritance or estate tax.

Although there is currently no federal inheritance tax, certain states choose to levy this tax.

Only six states have an inheritance tax.

A dozen states plus the District of Columbia have an estate tax.

The threshold for these can be lower than the federal limit.

Missouri and Kansas are not included in either of these groups.

Whew.

You transfer the life insurance policy as a gift.

If you are trying to avoid inheritance or estate taxes, you could transfer your life insurance policy to your beneficiary (as long as that beneficiary is not your spouse) while you are alive.

Depending on the value of the policy when you do this, you may have to pay a federal gift tax.

The federal gift tax exclusion is currently $15,000 per each recipient.

This is the amount you can gift to an individual in a year without owing a tax.

Even if you owe a tax, it is likely smaller than what would be owed in terms of inheritance or estate taxes.

The recipient of the policy will need to make payments on the policy so it will not lapse.

Your death benefit skips a generation.

Choosing your grandchildren rather than your children as beneficiaries will make the benefit taxable according to the IRS.

Why?

The generation-skipping transfer tax (GSTT) applies to gifts made to a family member more than a generation younger than you.

It also applies to a relative who is not related to the decedents and is more than 37½ years younger.

Fortunately, the GSTT is the same as and part of the overall estate, gift, and generation-skipping transfer tax magic number of $11.58 million noted above.

Your life insurance is paid in installments.

Your life insurance policy may have an option to pay the benefit in a single transaction or in installments.

If the benefit is paid in installments, the heirs will need to pay taxes on any interest on the funds while they are held by the insurance company.

You withdrawal from your cash value of the life insurance policy.

Do you have a a permanent life insurance policy?

If yes, you have a savings component known as the “cash value”.

Some of your premiums are used to fund the cash value account.

Any withdrawals made from the account must not exceed your payments made into the policy.

If you make withdrawals greater than the amount you have paid into the policy, the withdrawals will be taxed.

You have a group life insurance policy.

Some businesses provide an option for their employees to get life insurance through the company.

The group policy benefits can be taxed if the payout is greater than $50,000.

You sell your life insurance policy.

Should you choose to sell your policy to an investor or buyer for cash (also known as a "life settlement"), this individual will receive the death benefit when you die and continue to make payments toward the policy while you are alive.

The money you receive from this sale will be taxed as income.

Working with an experienced estate planning attorney will help you align your life insurance policy decisions with your comprehensive estate plan.

Reference: MoneyWise (Oct. 12, 2020) “Are Life Insurance Benefits Taxable?”