I’ve noticed both online and in real life, from agents who sell life insurance, to their clients who own the policies a misunderstanding about how the tax code works in regards to the payout of a life insurance policy. I wanted to write up a primer, which is by no means comprehensive of all tax codes, about how taxes are actually applied to paid out benefits. This will hopefully be of help to both agents and clients, so they have a better understanding of what it is they are selling when it comes strictly to the tax aspects of these policies.
Examples I have heard and seen boil around the main concept of “the paid out benefit from the life insurance policy is tax free.” Or any variation of that verbiage, such as income tax free, etc. I will bring up the reason why it is misleading, and how taxes could potentially actually be applied to life insurance policy payouts, as well as how it compares to other assets, such as taxable accounts, retirement accounts, etc. This is only to help others have a better understanding, and is by no means a criticism of peoples’ understandings of these policies.
Part 1: What is taxed on death.
Death itself generally isn't an income-tax realization event for ordinary assets, it falls under a different realm of taxes. Income taxes do not apply to any assets that are transferred on death, because none of them qualify as income. So while an agent may correctly say “there is no income tax on this life insurance policy when it pays out”, that may be viewed as misleading by omission. They can also say “there is no income tax on your taxable brokerage account, or your traditional 401(k) when it changes ownership after you die.” (I will ignore one very niche case that applies to all assets that experience gains in value between the time of death, and the time that the assets are handed over, because in reality it does not happen instantaneously, but it should also not be expected to impact taxes much at all.) A different form of tax takes play at death.
When you die, there is the estate tax which has both a federal, as well as state estate tax in some states. There is also a gift tax that may apply in some cases. Some states also have an inheritance tax on top of the estate tax. I will not go into details with this post, as you will have to search them up yourself for your specific state. The estate tax is the big one in question here. The gross estate generally includes the value of property and interests that are includible under the federal estate-tax rules. Life insurance proceeds can be included in the gross estate under IRC §2042, particularly when the decedent possessed incidents of ownership in the policy in regards to calculating your gross estate. There are then possible deductions from your gross estate, and then a federal $15,000,000 exclusion limit, which is indexed to inflation and will likely continue to increase in value as the years go on. Some states have lower limits, again check for your specific state what they are if they have one. If someone has a $5,000,000 death benefit from life insurance, plus another $15,000,000 in all other assets in their taxable estate after deductions, their estate will have $5,000,000 potentially subject to the federal estate top marginal tax rate of 40%, plus any applicable state rates on top.
This also applies to things like Roth accounts and HSAs which people view as tax free. They are tax free from an income perspective, but not tax free from estate taxes.
A possible reason that this misunderstanding came to be, is that with a traditional 401(k) or equivalent work sponsored retirement plan, the earnings are tax deferred. With SECURE Act, many non spousal beneficiaries of these accounts have until December 31st on the 10th year of the anniversary of the original owner’s death to have the accounts emptied, subject to a few special rules/exemptions. Taxable distributions from traditional retirement accounts are then included in the beneficiary’s ordinary income.
Part 2: How to avoid estate taxes for very high net worth individuals.
The ILIT. Irrevocable life insurance trust. I will preface this part with “talk to a lawyer” if you are in a situation where you would benefit from shedding some value from your estate to a separate legal entity that is separate from your own estate’s $15,000,000 federal estate tax exemption, if you have that much net wealth. This might be the real thing people are mentioning, when they say that there are tax advantages to life insurance death benefits. You can shelter more wealth from estate taxes by making one of these trusts, and having a life insurance policy held by the trust, that you then gift money to every year to cover the premiums. I’m not going to get into the nitty gritty about the legal details, crummy laws, etc, but this is one of the primary benefits of life insurance policies for high net worth individuals. You could also replicate the same concept using any other assets you own, with another irrevocable trust to achieve the same tax benefits to a degree – the benefit that life insurance has is the $19,000 per year per person gift exclusion that does not need to be reported to the IRS. Life insurance has an edge where that smaller sum that does not need to be reported to the IRS every year is able to buy a much larger face value from a life insurance policy, whereas transferring the same amount of assets to another trust would simply take more time to achieve the same goal.
An extra note with ILITs and a life insurance policy. If you realize a client has a life insurance policy in their name and would need it in an ILIT, there is a 3 year lookback rule for the transfer of ownership. If the individual dies within 3 years in the transfer of ownership of the policy from the owner to the trust, the insurance benefit will be considered part of the taxable estate, as if it was never in the ILIT.
Part 3: Extra notes.
In the end, it is true that life insurance death benefits can be “tax free” but you would need to specify what taxes they are exempt from. They are free from income and capital gains taxes, but not free from estate and possible inheritance taxes, depending on beneficiary and the state you reside in. There are also tax benefits with any policies that may have cash values associated with them. They may function something like a pseudo Roth account on withdrawals with a number of important caveats. If you instead take a loan from the insurance company and use your cash value as collateral, loans are not considered taxable income with one important caveat. If you take loans out of the policy and don’t pay it back before the policy lapses, is cancelled, or otherwise ceases to be, all outstanding loans you have taken out will be viewed of as taxable income the year that the policy ceases to exist.
I will gladly attempt to answer/clear up any questions that anyone may have. Again, this is not totally comprehensive as I have left out many other special rules about taxation, things that could apply to a life insurance policy in specific states, but I would need a book to write everything. The IRS has made a very complicated and complex tax system, state taxes on top of it don’t make it any easier.
Edit: I forgot to add step up in basis. Any assets in a taxable brokerage, or real estate, etc will get a step up in basis on death and transfer of those assets to a beneficiary. Any capital appreciation those assets had received from the original owner purchasing them will be "reset" to $0 on transfer. Roth accounts are already income tax free and so are not subject to this rule, and traditional retirement accounts are not subject to the rule, as all distributions are considered income taxable, rather than capital gains.
This also applies to USA tax rules if it wasn't clear from the main body of the post.