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Life insurance is one of the best ways to secure your family’s financial needs in the event of your untimely death. It essentially acts as a financial safety net and helps your family cope with the loss of a steady income source.
One question that often pops up while discussing the subject of life insurance is – is the death benefit taxable?
It is entirely understandable, as most people are not thrilled with the idea of giving away a significant portion of the insurance payout to the government, especially at a time when they need it the most.
In this article, we take a detailed look at the tax implications of life insurance policies.
Are Life Insurance Proceeds Taxable?
Life insurance proceeds, which are paid out as a lump sum, are not taxable. Your beneficiaries can use it to pay off their debts, outstanding bills, mortgage, or any other financial need they might have.
This is one of the main reasons why life insurance remains an attractive option for people who want to make sure their family’s financial needs are taken care of even after their passing.
There are, however, certain exceptions to this rule. The proceeds from your insurance policy could be taxed under certain conditions.
Lump Sum vs. Installments
Life insurance payouts are not taxable only in cases where they are paid out as a lump sum. If your beneficiary chooses to have your policy’s death benefit paid out in installments, the insurance company usually pays interest on the outstanding sum. In this case, the interest amount paid out to your beneficiary is taxable.
It should be, however, noted that even in cases where the death benefit is paid out in installments, the death benefit itself is not taxable. Only the interest paid on the death benefit is taxed.
Let us say, for instance, your policy has a face value of $500,000. If it is paid out in installments, and if it earns a 10% interest during the course of the payments, your beneficiaries have to pay taxes only on the $50,000 (the income earned via interest), and not on the $500,000 (the original payout).
Does Estate Tax Apply for Life Insurance Payouts?
The estate tax is an important factor you need to consider while designating a beneficiary for your life insurance policy.
If you name your spouse as the beneficiary of your policy, the death benefit is passed on to them directly. The payout is not added to your estate, irrespective of how large a sum it is. This rule, however, applies only to your spouse. If you name your children, parents, or any other person as your beneficiary, the death benefit is usually added to your estate. In these types of cases, if the total value of your estate exceeds the exemption limit, your beneficiaries have to pay taxes on it.
Currently, the exemption limit for an estate tax is $11 million for a couple. If your estate value, including your life insurance payout, exceeds the limit, your beneficiaries have to pay taxes on the amount over the exemption limit.
Are Living Benefits Taxable?
If your life insurance policy has an accelerated death benefit option, you will receive a portion of your death benefit in case you are diagnosed with a chronic or terminal disease. Since you receive the amount while you are still alive, it is considered a ‘living benefit’. Just like death benefits, living benefits too are not taxable.
Is the Cash Component of a Permanent Life Insurance Policy Taxable?
Permanent life insurance policies (whole life, variable life, universal life, and variable universal life) usually have a cash component, which grows in value throughout the term of the policy. The cash component is not taxable.
Many insurance companies allow you to withdraw or borrow money from your policy’s cash component. This amount you withdraw or borrow is not taxable, as long as it does not exceed the total amount of premiums you have paid into the policy.
Are Dividend Payments Taxable?
Mutual insurance companies tend to pay dividends to their policyholders from time to time. The structure of these companies is such that the policyholders are technically the owners, so the profits are usually shared among everyone in the form of dividends.
The dividends are not taxable, as long as they do not exceed the total amount of premiums you have paid.
If, on the other hand, the amount you receive as dividends is more than what you paid towards premiums, you have to pay taxes on the excess amount.
What Happens if You Surrender a Permanent Life Insurance Policy?
If you surrender your permanent life insurance policy for any reason, you will receive the accumulated cash portion of your policy. In this case, your tax liability depends on the amount you receive as cash surrender value.
If it is lesser than the total amount of premiums you paid, you do not have to pay any taxes. If it is more, you have to pay taxes on the excess amount.
Tax Implications on Life Insurance Settlements
If, for some reason, you no longer need your policy, you can sell it to a third party via a settlement. When you do, you might have to pay income tax as well as capital gains tax, depending on the settlement amount you receive.
Let us say, for instance, your policy has a cash value of $200,000 and you have paid $150,000 towards premiums. Now, if you sell your policy for $250,000, you can calculate your tax liability in the following manner.
Taxable income = cash value ($200,000) – premiums paid ($150,000), which is $50,000.
Capital gains = total gains – taxable income.
You can calculate your total gains by subtracting the premiums paid ($150,000) from the settlement amount you received ($250,000), which in this case is $100,000.
Now, you can calculate your capital gains by subtracting the taxable income ($50,000) from the total gains ($100,000), which is $50,000.
Can You Claim Tax Deductions for Insurance Premiums?
Apart from the tax implications of living and death benefits, this is the most common question that people ask when it comes to insurance policies. The short answer is – no.
The premiums you pay are considered personal expenses by the government, so they are not eligible for a tax deduction.
This rule, however, is applicable only for individuals. If you are a business owner who offers group insurance for your employees, the premiums you pay for each employee (up to $50,000 in coverage) are deductible.
How to Avoid Taxes on Life Insurance?
One of the best ways to avoid paying taxes on your insurance policy is to set up an irrevocable trust. By doing so, you are essentially transferring the ownership of the policy to the trust, which means the proceeds from the policy will no longer be part of your estate.
At the same time, you can decide who gets to be the beneficiary of the policy, so that they can receive the money after your passing.
There are two important factors you should keep in mind while setting up an irrevocable trust for your insurance policy.
- In the event of your death within a three-year period of setting up the trust, the policy will still be considered yours and added to your estate. The rule is in place to prevent people who are on their deathbed from gifting away their insurance policies to their loved ones, just to avoid estate taxes.
- If, at the time of setting up the trust, the accumulated cash value of your policy exceeds the gift tax exemption limit, you have to pay gift tax, only after which you can transfer the ownership of the policy to the trust.
Opting for a Permanent Life Insurance Policy
If you can afford to, you can press the button for a permanent life insurance policy instead of a term life insurance policy, as the former offers you more tax benefits. The affordability factor needs to be considered here because permanent policies typically cost more than term policies.
Permanent life policies generally have three components – cash value, dividends, and death benefit, all three of which are not taxable under normal circumstances.
You have to pay taxes on the cash value and the dividends you receive only if they exceed the total amount of premiums you have paid until that point in time. Otherwise, they are completely tax free. The death benefit, on the other hand, is not taxable under any circumstances, as long as it is paid as a lump sum.
This is why people from high-income households generally prefer to buy permanent life policies, as it allows them to pass on a large sum of money to their beneficiaries without any tax liabilities.
Choosing the Right Policy
As you can see, the proceeds from a life insurance policy could be taxable or non-taxable, depending on various factors that are listed above.
So, if you are the primary earner in your household, you not only have the responsibility to choose a policy that can cover your family’s financial needs after your passing, but also to set it up in such a way that the proceeds are passed on to your beneficiaries without any added tax burden. That is only logical right?
Life Insurance Payouts and Taxes by Jonathan Holloway