Ben Franklin argues that nothing in life is certain expect death and taxes, but many with life insurance policies may wonder when the latter occurs, if taxes follow as well.
The good news is that, for many of us, life insurance payouts are considered the reimbursement of a loss and not additional income. Thus, they likely will not be taxable.
When Is Life Insurance Not Taxable?*
Payout to beneficiaries: If you were to pass away, the payout your beneficiary would receive may not be taxed. Since this type of revenue is considered the reimbursement of a loss, the IRS does not view it as income and doesn't require it to be reported. Is life insurance tax deductable? The beneficiary does not need to deduct the tax becuase there is no tax on the payout of most life insurance policies. There can be some exceptions to this rule (for instance, a large estate), but we'll cover that below.
Payout to a spouse: Your spouse is exempt from paying any taxes on a life insurance payout, even if estate taxes would normally apply.
Cash value gains: Some permanent life insurance policies may pay out not only a large sum upon an insured's death, but are also designed to increase in cash value through investments paid by the owner. Any increases, or investments, in the cash value of the policy are not considered income and will not be taxed.
Surrender payouts: To surrender life insurance simply means that you are turning in a cash value policy for its current value.The money you receive for surrendering your policy will not be taxed so long as the payout is less than what you'd paid into the policy during its lifetime.
When Is Life Insurance Taxed?*
Payouts from a large estate: Even though in many cases payouts to beneficiaries will not be subject to income taxes, there is an exception. A life insurance policy is considered to be part of an estate, and if said estate is large enough (nearly $5.5 million**), then a life insurance payout could be subject to an estate tax. One way to potentially avoid this type of tax is to transfer the policy to an irrevocable trust. If done more than three years prior to your death, this may keep your life insurance from becoming part of your estate.
Interest on payouts: Your beneficiary may have the option to collect their payout in installments rather than one lump sum. If they do elect to do so, then the insurance company will often pay interest on the balance. That interest may be subject to income tax.
Profit from surrendering a cash value policy: As discussed previously, surrendering a cash value policy enables you to collect the policy's current value. If that value is higher than what you had paid into it during its lifetime, you may have to pay income taxes on the difference.
For many of us, it's possible that a life insurance payout will never be taxed. However, for those with significant assets to protect, knowing which type of life insurance policy is best for you and how to set it up in order to provide the most to your heirs could be invaluable.
For more information on how to protect your loved ones and your assets, we suggest you consult a financial advisor. If you are interested in purchasing a life insurance policy, you can request a quote with us.
Disclosure: This information is general in nature, may be subject to change and does not constitute legal, tax or accounting advice from any company, its employees, financial professionals or other representatives. Applicable laws and regulations are complex and subject to change. Any tax statements in this material are not intended to suggest the avoidance of U.S. federal, state or local tax penalties. For advice concerning your situation, consult your professional attorney, tax advisor or accountant.