- 1 Beneficiary – Receipt of Insurance Proceeds
- 2 Beneficiary Pay-Out Example
- 3 Purchaser – Surrender Value
- 4 U.S. (Domestic) Dividends, Interest or Capital Gain
- 5 Foreign Life Insurance Dividends, Interest or Capital Gain
- 6 Foreign Life Insurance: FBAR & FATCA Reporting
- 7 Common IRS Penalties on Foreign Life Insurance
- 8 Are You Out of IRS Compliance?
Is Life Insurance Taxable by the IRS? That answer will depend on various factors, specifically:
- The purchaser of the Life Insurance vs. the Beneficiary
- Income earned from the Life Insurance Policy
- Surrender Value (cash-in) vs. Premium Payments
The following is a summary of the various different types of common income related issues that may be generated from owning or cashing in a life insurance.
Beneficiary – Receipt of Insurance Proceeds
When a beneficiary receives life insurance payments, typically they are not taxable by the IRS under U.S. tax law. A common example is life insurance benefits received by a beneficiary after the purchaser of the policy dies.
Beneficiary Pay-Out Example
David purchases a $1,000,000 life insurance policy for his children. The policy is based on the life of David and David pays the premiums.
At 63 years old, David unfortunately passes away as a result of an accident. The policy was not set to expire until David was 65 years old. David continued to make premium payments until his death, so that the policy premiums were paid.
At David’s death, his two children are the beneficiaries of $1 million life insurance policy. Each child receives $500,000.
Under almost all circumstances, the $500,000 is not taxable to the beneficiaries.
Purchaser – Surrender Value
This is a different type of scenario, in which the purchaser of the life insurance surrenders or exchange the policy back to the insurer. For example, Denise purchase life insurance with her Aunt as the beneficiary.
After certain amount of time, before Denise passes away, she surrenders the life insurance policy to the company. Denise purchased the life insurance policy for $8000 of the premiums over a ten-year period. At the time she surrenders insurance policy, Denise receives $13,000 back from the insurance company.
As a result, Denise is earned $5000 as a direct result of paying the insurance premiums.
Here’s the kicker: Unlike Long-Term Capital Gain (LTCG) in which you purchase an asset, sell it for higher value and the LTCG is taxed at a reduced tax liability – the same rules do not apply for life insurance.
In other words, after Denise surrenders her policy and receives the $5000 increase in value, she will include the $5000 on line 21 of her tax return which is the section for (other income).
Therefore, the amount of increase in value of the life insurance policy being surrendered will be taxed at her ordinary tax rate. So if she’s being taxed at 10% and the additional $5000 does not bump her up to the next tax rate, she will pay 10% on the increase.
Likewise, if Michelle is in a higher tax bracket she would pay a higher progressive tax rate for the same income.
U.S. (Domestic) Dividends, Interest or Capital Gain
The taxation of a Domestic or U.S. Life Insurance Policy is different than the taxation of a Foreign Life Insurance Policy.
When it comes to dividends, it gets more complicated.
If the policy is earning passive income along the way (participating Life Insurance), under most circumstances Denise will not pay tax on those earnings, even if those earnings are not distributed — as long as the total value does not exceed the amount of premiums paid.
But, if the dividends remain with the policy, accrue and exceed the value of the premiums paid, then dividends may be taxed.
When it comes to interest, there are two typical situations, which results in the recipient receiving interest in having to pay tax:
– In the first situation, where the purchaser of the policy has dividends accruing and not being distributed. While the dividends are generally not taxable, the interest on the dividends would be.
– In the second situation, with the beneficiary decides to not take a lump sum payment rather prefers gradual payments, any interest earned on the money that is sitting in the account/policy pending distribution to be taxable as well.
Foreign Life Insurance Dividends, Interest or Capital Gain
When it comes to Foreign Life Insurance Policies (sometimes referred to as “Life Assurance”), the rules are much different. The Internal Revenue Service is not a big fan of foreign life insurance policies, because they are not subject to the same strict reporting and disclosure rules as U.S.-based life insurance.
As such, typically under almost all circumstances if the policy is generating any passive income, the passive income will be taxed – despite whether it is being distributed or not, and despite whether the dividends exceed the value of the amount of pay-in for the policy.
Foreign Life Insurance: FBAR & FATCA Reporting
A foreign life insurance policy is typically considered both a foreign account specified foreign financial asset for foreign reporting purposes.
In other words, if the value of the policy which the threshold requirements for filing either the FBAR or FATCA Form 8938, a person has to file the form annually. If they fail to do so, the IRS can issue substantially high fines and penalties against the owner of the policy.
Common IRS Penalties on Foreign Life Insurance
The following is a summary of penalties as published by the IRS on their own website:
A penalty for failing to file FBARs. United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the year. The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign financial account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
Beginning with the 2011 tax year, a penalty for failing to file Form 8938 reporting the taxpayer’s interest in certain foreign financial assets, including financial accounts, certain foreign securities, and interests in foreign entities, as required by IRC § 6038D. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A penalty for failing to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Taxpayers must also report various transactions involving foreign trusts, including creation of a foreign trust by a United States person, transfers of property from a United States person to a foreign trust and receipt of distributions from foreign trusts under IRC § 6048. This return also reports the receipt of gifts from foreign entities under IRC § 6039F. The penalty for failing to file each one of these information returns, or for filing an incomplete return, is the greater of $10,000 or 35 percent of the gross reportable amount, except for returns reporting gifts, where the penalty is five percent of the gift per month, up to a maximum penalty of 25 percent of the gift.
A penalty for failing to file Form 3520-A, Information Return of Foreign Trust With a U.S. Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts under IRC § 6048(b). The penalty for failing to file each one of these information returns or for filing an incomplete return, is the greater of $10,000 or 5 percent of the gross value of trust assets determined to be owned by the United States person.
Are You Out of IRS Compliance?
At Golding & Golding, we limit our practice to international tax law – and specifically IRS offshore voluntary disclosure. If you have for life insurance policies or other accounts and assets abroad that you have not reported to the IRS, it is important to get into IRS compliance.
One of the fastest and safest methods for getting into IRS offshore voluntary compliance is through one of the voluntary disclosure.
We Can Help You.