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What to Know About Taxes on Life Insurance

Life insurance is an important part of financial planning. It becomes increasingly important as people get older and begin to think about ensuring the care of their family after they die. However, there are important tax implications to consider when deciding to use life insurance and when naming your beneficiaries. From taxes on payouts to estate tax issues, there is a lot of information to manage. It might make sense to find a financial advisor who can help you navigate the various life insurance products available. SmartAsset can help you find the right one who is right for you with our free financial advisor matching service.

Taxes on Life Insurance Payouts

How does the IRS tax life insurance proceeds? The short answer is that lump-sum death benefits generally 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 beneficiaries receive the death benefit in a lump sum. 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. 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.

Taxes on Life Insurance Installment Payments

What to Know About Life Insurance Taxes

Some life insurance policyholders and beneficiaries choose to structure their policy so that the beneficiary receives the payment 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 that the death benefit earns in the period between the death of the policyholder and the disbursement of funds to the beneficiary.

Life Insurance and Estate Taxes

Death benefits from a life insurance policy might be subject to the estate tax. This depends on the size of a policyholder’s life insurance policy and other assets. 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. The beneficiary can be 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 withdraw that is greater than the amount you paid in premiums is considered taxable income. 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.

Bottom Line

What to Know About Taxes on Life Insurance

With careful 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.

Tips for Financial Planning

  • Financial advisors can be a huge help when it comes to life insurance planning. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • If you invest in life insurance, it’s important to not only pick the right product but also to get the right amount. SmartAsset’s life insurance calculator gives you an idea of how much you should get.

Photo credit: ©iStock.com/dblight, ©iStock.com/Hailshadow, ©iStock.com/Weekend Images Inc.

Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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