If you currently have a life insurance policy or you’re the beneficiary of someone else’s life insurance policy, you may be wondering what the tax implications of that policy will be. You may have heard that the proceeds of a life insurance policy aren’t subject to income taxes, but the reality is a little more complicated than that.
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Taxes on Life Insurance Payouts
The short answer to the question of how life insurance proceeds are taxed is that lump-sum death benefits are not subject to income taxes. Most people who buy life insurance pay for it in a series of premiums. When the policyholder dies, the death benefit is paid out in a lump sum to the beneficiary. When life insurance is paid for and disbursed in this way, the benefit is not taxable unless it triggers the estate tax (more on that below).
If you opt for permanent life insurance (as opposed to term life insurance), your policy can accumulate cash value without triggering taxes. And for policies that pay dividends, those dividends are generally not taxable, unless you receive more than you’ve paid in premiums.
As you can see, there are plenty of ways to get tax-free gains from a life insurance policy. However, there are certain life insurance decisions that can lead to taxation of some or all of the life insurance policy. Let’s take a look at some cases in which life insurance is taxable.
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Taxes on Life Insurance Installment Payments
Some life insurance policyholders and beneficiaries choose to structure their policy so that the payment is doled out to the beneficiary in annual or monthly installments rather than in a lump sum. In that case, the bulk of the policy earns interest over time. The interest is considered taxable income. The same goes for any interest the death benefit earns in the period between the death of the policyholder and the disbursal of funds to the beneficiary.
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Life Insurance and Estate Taxes
Depending on the size of a policyholder’s life insurance policy and other assets, death benefits from a life insurance policy might be subject to the estate tax. If you want to exclude your life insurance policy from your taxable estate when you die, one option is to name your spouse as your beneficiary. Life insurance policies left to a spouse are not counted as part of the estate of the deceased. Another option is to transfer ownership of the policy to your beneficiary, whether it’s your spouse or another person in your life. However, that ownership transfer must have been in effect at least three years before your death to avoid taxation.
Surrendering or Withdrawing from Your Life Insurance Policy
Say you’ve been paying monthly premiums on a universal life insurance policy. The premiums you’ve paid do not yet equal the cash value of the policy. However, you decide you want to withdraw money from the policy. Any money you take out of the policy that is greater than the amount you paid in premiums is taxable income. And if you surrender the policy altogether, the difference between its value and what you’ve already paid in premiums is taxable income. To get around the tax implications of a withdrawal, policyholders who want access to the money in their life insurance policy can take a loan from the policy rather than make a withdrawal.
With careful planning and management of your life insurance policy you can shelter a sizable chunk of money from the IRS for your beneficiaries. The general rule with life insurance and taxes is that if you take more money out of the policy than you paid into the policy, you may trigger taxes. That goes for interest your policy earns and for money you take out yourself, in a surrender or withdrawal.
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