Is life insurance taxable? This question is one of the most frequently asked questions when it comes to life insurance. The short answer to this very popular question is, no it’s generally not. In most cases the death benefit received from a life insurance policy is tax-free.
Keep reading to learn more about life insurance and when you could possibly pay taxes on death benefit proceeds.
As the beneficiary of a life insurance policy, it is very important to know whether or not you will need to pay taxes on any proceeds received from a life insurance policy.
Because life insurance proceeds are generally paid out as one lump sum payment, it’s very common to assume that taxes will need to be paid on the money received.
But as mentioned above, the money received from a life insurance payout will be free of taxes. However, the complete answer is a bit more complex than that, as there are some slight chances it could be taxed.
That’s why we’ve put together this beneficiary guide to help you understand what you need to know about life insurance and when you could possibly have to pay taxes on any death benefit proceeds.
What is Life Insurance?
Life insurance is a way for your loved ones to make sure that you’ll be financially secure if they pass away.
Life insurance coverage is paid to an insurance company in the form of premium payments over time. After death, the benefit amount is paid to the beneficiary in the form of a lump sum. If you’re reading this, you’re probably a beneficiary of someone’s life insurance policy.
Most of the time, the amount you receive won’t be taxed, but there are a few exceptions to this rule. Let’s take a look at what they are.
Examples of when Life Insurance is Taxable
When you ask “is life insurance taxable?” the answer is almost always no, except in some situations. Here are the key reasons why life insurance proceeds might be taxable.
Profits from the Cash Value
Life insurance policies that have the ability to earn cash values such as universal and whole life insurance have the potential of being taxed.
However, in order for a tax occurrence to happen, the cash value has to be greater than all of the money that has been paid into the life insurance policy.
If this has occurred, the taxable portion will only be on the profits earned and not the actual death benefit.
If the life insurance policy has earned cash values but is less than what has been invested into the life of the policy, you will not owe taxes on the surrender value.
Interest Earned on the Death Benefit
There are a few life insurance companies that offer a unique payout option of a life insurance death benefit.
Instead of receiving a lump sum payout, the owner of the life insurance policy can elect a structured payout plan of the death benefit.
This payout can pay a smaller lump sum payout at the time of death and then schedule payments over the course of several years.
Since the beneficiary is not receiving the full death benefit upfront, there is the potential that the proceeds will earn interest.
The interest earned on the death benefit funds can be taxed.
Loans taken from Policy Cash Values
Life insurance policies that have the ability to earn cash values also have the ability to provide loans if needed.
The great thing about being able to take loans from the cash value of a life insurance policy is that you can pay it back at your leisure.
However, if you choose to borrow from the cash value, there will be a required annual interest rate determined by the life insurance company.
If the loan remains outstanding at the time of death, you may need to pay taxes on the remaining loan balance. Furthermore, if the loan has not been paid off, the remaining balance of the loan will be repaid from the death benefit proceeds.
Wealthy Estate Payouts
As you can see a common trend regarding taxes and life insurance usually involves the cash values and not the actual death benefit. Well, this can be the one example in which a life insurance payout can be taxed and it involves large wealthy estates.
When a life insurance policy involves a policy owners estate and the estate is worth a considerable amount of money (usually $5.5 million or more), the death benefit can be subject to estate taxes.
One very common way to avoid potential estate taxes is to transfer the life insurance policy to an irrevocable trust.
When the insurance proceeds are in the trust, they are no longer part of the estate, and not subject to estate taxes.
In order to avoid estate taxes, the life insurance policy must be transferred at least 3 years prior to the death of the insured. If not, you will likely be subject to estate taxes on the death benefit proceeds.
When is Life Insurance Not Taxable?
As a beneficiary wondering “is a life insurance death benefit taxable?” the answer is no.
As you can see above, almost every case in which life insurance can be taxable, it’s usually towards the cash values of the life insurance policy and not the overall death benefit.
Except in a small percentage of cases (such as very wealthy estates), you can guarantee that you will not owe any taxes on a life insurance payout.
Let’s take a look at the times when life insurance is not taxable.
Payout to the Beneficiary
This is most relevant to you, the beneficiary. The purpose of life insurance is so the policyholder can make sure you are taken care of after they pass. So it makes sense that you won’t need to pay taxes on what you get from the payout.
The major exception to this rule is the estate tax mentioned above. However, this really only affects a small percentage of life insurance cases.
If your estate is large enough to be taxed, but you’re the spouse of the policyholder, you still won’t have to pay estate taxes on the insurance payout.
Surrendering the Policy
If the policyholder no longer wants a permanent life insurance policy and decides to surrender it, a lump sum will be paid out. If the surrender payout is below the amount that was paid in, no taxes are owed. If it’s above that amount, the profit margin may be subject to income taxes.
Policyholders own mutual insurance companies, which sometimes use dividends as a way to give money back to those policyholders. Luckily, the dividends won’t be taxed, unless the amount is above the premium amount that was paid in.
What about Premiums? Are those Tax Deductible?
Off the subject of death benefits, another very common tax question we get is “are life insurance premiums tax deductible”?
The answer, unfortunately no the premiums paid for life insurance are not tax deductible. They are considered a personal expense by the IRS.
Now, if you’re the owner of a business there may a chance that the premiums paid on a key man life insurance policy could be tax deductible. But, it all depends on how the policy is set up, who the owner will be, as well as the beneficiary.
How Life Insurance Can Help You
Now that you know the answer to “is life insurance taxable?” it’s time to take a look at why life insurance is so helpful.
For many people, this is a great way to avoid paying taxes while still ensuring the money ends up where it’s supposed to be. Even estate taxes can be avoided when a life insurance policy is combined with an irrevocable trust.
This puts more money in the pockets of you – the beneficiary – and less in the government’s pocket, which is appealing to a lot of people.
Do you need to get life insurance? We’ve got you covered. Contact us today to find out how we can help.
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