When Life Insurance Becomes Taxable
According to the most recent estimates from the US Census Bureau, the population of people over the age of 55 grew twenty times faster than the population of people younger than 55 between 2010 and 2020. The fastest growing age group was people between the ages of 65 and 74, who experienced a nearly 50% increase in growth in those ten years.1
Living this long may have unexpected tax consequences. Here's why.
Many older life insurance policies mature at a specific age, typically 95 or 100. If the insured individual attains that age, the policy's cash value may be paid out to the policy owner in lieu of a death benefit payment.2
This payout may be taxed as ordinary income on the amount that exceeds the policy owner's cost basis (or the sum of after-tax premiums). The after-tax amount would then become part of the policy owner's estate and may be subject to further taxation upon the policy owner's death.3,4
If a policy is owned by an irrevocable trust, the trust is responsible for any tax owed, though the proceeds would not become part of the insured's estate if the insured had no incidents of ownership.3,5
Avoiding the Taxable Risk
This taxable risk may be mitigated through a maturity extension rider, which allows the policy to continue until the death of the insured. Many newer life policies come with a higher maturity age (like 120) or an indefinite period.6
1. Brookings.edu, January 11, 2021
2. Several factors will affect the cost and availability of life insurance, including age, health, and the type and amount of insurance purchased. Life insurance policies have expenses, including mortality and other charges. If a policy is surrendered prematurely, the policyholder also may pay surrender charges and have income tax implications. You should consider determining whether you are insurable before implementing a strategy involving life insurance. Any guarantees associated with a policy are dependent on the ability of the issuing insurance company to continue making claim payments.
3. Investopedia.com, May 25, 2022
4. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.
5. Using a trust involves a complex set of tax rules and regulations. Before moving forward with a trust, consider working with a professional who is familiar with the rules and regulations.
6. TheBalance.com, November 5, 2021