Getting life insurance is vital when you’re making plans to financially secure your family’s future, and figuring out how taxes play into that is important.
Many consumers have misunderstandings about whether their life insurance policies are taxable. While in most common cases they aren’t, there are some circumstances when a death benefit gets taxed.
Choosing the right policy is time-consuming and complicated if you don’t have the right resources. Insurify makes it quick and easy to compare rates from the highest-rated life insurance companies in the industry.
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Is the payout from life insurance taxable?
The payout out of a life insurance policy is commonly known as the death benefit. The death benefit is rarely ever taxed.
Since the income from a death benefit isn’t considered gross income, it’s not taxable. The IRS has specifically stated, “Generally life insurance proceeds you receive as a beneficiary due to the death of an insured person aren’t includable in gross income, and you don’t have to report them.”
If you have a whole life policy, your death benefit will likely include cash value. Cash value is the interest that builds in your policy over time. This cash value can be taxed depending on how you use it in your policy.
Typically, if the cash value is taxed, it’s because the policyholder has gains on their policy. Gains occur when more funds have been taken out of a policy than put into it. Policy gains are calculated based on the amount of money you’ve taken out minus the premiums you’ve paid in or premiums paid minus the funds you received.
The longer your policy is in force, the smaller the chance of a cash value withdrawal to create a gain on your policy. You won’t have gains in a term life insurance policy since no funds can be taken out or borrowed from a term policy.
Is the cash value of a life insurance policy taxable?
As mentioned before, whole life policies have a cash value. Cash value is withdrawn from a policy one of two ways. How and when this cash is withdrawn will determine if it is taxable.
If you borrow your cash value as a loan, there will be an interest rate, normally between three and seven percent. Taking cash value out as a loan is not taxable as long as the policy is active. If your loan is higher than your policy’s coverage, the portion that exceeds the policy will be taxable income.
The other way to take out cash value is to surrender your policy. Once a policy is surrendered, it is no longer in force and has a higher likelihood of being taxed. But that is not always the case. When you surrender, the cash value is taxed only when you’ve taken out more than you’ve put in.
Gift Taxes on Life Insurance Policies
In some cases, there is a gift tax added to a life insurance policy. This tax is added when the policy owner, insured, and beneficiary are three different people or establishments. Policies like this are commonly known as the “Unholy Trinity” or “Goodman’s Triangle.” Below is an explanation of how each role is played in this type of policy.
- Policy owner: the person who purchased the policy and pays the premium
- Insured: the person whose death would result in a payout
- Beneficiary: the person who will receive the payout if the insured passes
If the policy owner, insured, and beneficiary are different people, you want to make sure your policy is protected from unexpected tragedies. Put in place multiple beneficiaries, and list an owner designee in case you pass away before the insured.
Whole Life Insurance and Taxes
When the question of taxes is mentioned, whole life policies are more complex. The policy has more tax implications and more risk for a taxable event because of the policy’s cash value. Keeping an eye on your cash value will be essential if you choose to borrow against your policy or choose a cash surrender.
When you’re signing up for a whole life policy, most insurers provide you with a policy illustration. This illustration displays how the policy value will grow over time. If you’re making plans for your estate, be sure to factor in the future payout from your life insurance policy. Knowing how much value and interest will be in your policy 10, 20, or 30 years down the line will help you avoid tax consequences.
Many policyholders are concerned with their estate being taxed after they pass and their beneficiaries receive the payout. Your estate being taxed is unlikely, but you want to have plans in place that will secure your family’s finances and avoid a tax bill.
If there is no beneficiary to claim the death benefit, the payout will go into your estate. Once the funds are included, it’ll be taxed with the rest of the estate. You can avoid this by securing multiple beneficiaries on your policy.
A key detail often missed over the years is updating your life insurance policy. When policies are in force for many years, a lot of life changes occur. You want to always be sure the beneficiary of your policy is who you want it to be and they are still living.
You’d be surprised how often the beneficiary of a policy is an ex-spouse or a parent who passed before the child. These are situations that cause complications when paying out a death benefit and have the potential to send your family to probate court.
In some cases, life insurance policies are owned by the life insurance trust rather than an individual. When the policy is owned by a trust, the trust is usually the beneficiary as well. If the funds of a death benefit are transferred into a family trust, it’s not included in the estate and is not taxable.
ABR Rider and Taxes
Whole life policies are known for having riders. Riders are added to a base policy to increase the benefits available to the policy owner. The Accelerated Benefit Rider (ABR) allows policyholders to use funds in the policy for medical emergencies. There are no tax penalties for taking funds out of the policy with the ABR rider.
Modified Endowment Contract and Taxes
A modified endowment contract, also known as an MEC, occurs when you have paid too much into your policy in the first seven years. When this happens, the IRS now views the policy as an investment, making the policy’s cash value taxable.
If you have a life insurance policy with a mutual life insurance company, you likely receive dividends each year, in most cases on your policy anniversary date. Insurers give you a variety of dividend options. Dividend options allow the policy owner to specify what will happen with their dividends each year.
Dividends from your mutual insurance company are not a tax liability and are not taxed unless you choose to let them sit in your policy. Letting dividends sit in your policy allows them to collect interest. This interest increases the death benefit and is taxable. The other option is to withdraw your dividends each year or request to have the funds automatically deposited into your bank account each year.
A partial withdrawal is a process that reduces a portion of your policy. Reducing your policy has a variety of benefits if you’ve had your policy for many years. A partial withdrawal does not always result in a policy being canceled.
Policyholders have the option to replace the funds that were withdrawn. Although whole life policies let you request a partial withdrawal, this process is most common for universal life policies. A universal life policy allows policy owners to experience more flexibility and combine their life insurance and assets.
On both a whole life and universal policy, a partial withdrawal can reduce or eliminate a previous loan that was taken from the policy or lower the coverage amount to make the premiums cheaper. Depending on how long you’ve had your policy, a partial withdrawal will eliminate your monthly premium. Partial withdrawals from your policy are not taxable, and you have the option to replace the funds to increase the death benefit.
Partial withdrawals are never available on a term life insurance policy.
Taxes on Lump-Sum Payouts
The life insurance payout is normally paid in one lump sum unless the policy owner or beneficiary specifies to have payments paid out in smaller amounts over time. If payments are made over the time the death benefit accrues interest, that interest is taxable. While interest is taxed, lump-sum payouts are tax-free for the beneficiary.
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Life Insurance and Taxes: Frequently Asked Questions
Are life insurance premiums taxable?
Life insurance premiums are not deductible on your tax return and do not result in any income taxes. When insurers implement the return of premium, premiums paid to the company over a period of 10 or more years are given back to the policy owner. Because this payment is processed as a refund and not a payment, these funds are returned tax-free.
Do you pay taxes on group life insurance?
Group life insurance is almost never taxed. The first $50,000 of coverage on a group policy is not included in your taxable income. Employers are instructed to include any amount above $50,000 into your income, and the insurance is subject to be taxed. Most people do not exceed coverage for over $50,000 on a group policy. If an employer offers term life insurance to an employee and they sign their spouse or children up, the coverage is not taxable as long as the coverage does not exceed $2,000.