Life insurance payouts generally aren’t considered taxable income; however, there may be exceptions.
If you sell your whole life insurance policy for cash and its settlement exceeds the cumulative total of all premium payments, a portion of any profit may be subject to taxes.
Premiums
As with any type of insurance policy, life insurance premiums must be paid regularly in order to remain active. While this may seem straightforward at first glance, understanding how the IRS treats life insurance premiums may make the task more complex than anticipated.
First and foremost, life insurance payments are generally not tax-deductible as seen by the IRS; as this expense falls into personal expenses like clothing or video games. But there are certain situations in which premium payments may be written off, including when used as employee benefits or when donated directly to charity.
Furthermore, death benefits that your beneficiaries receive typically do not incur taxes. This applies whether they use them for alimony or child care costs as well as mortgage or debt payments. Furthermore, cash value withdrawals or loans from permanent life policies usually aren’t taxed either, provided their loans don’t exceed total premium payments made into them.
On the other hand, if you take out too many loans or withdraw too often from your cash value account, your life insurer could terminate your policy and require that any gains that have accrued prior to this point be taxed as income.
Tax treatment of policies with investment features such as whole life or variable life insurance differs significantly; any gains that accumulate are exempt from income tax as long as they remain within the policy, however if cashed-in or surrendered any gains will be taxed as ordinary income.
Death Benefits
Life insurance death benefits typically aren’t taxed, making them easier for beneficiaries to use to repay debts or invest for the future. A lump sum payment will usually be distributed directly to them upon death and can be used towards paying off bills, providing income replacement to surviving spouses or putting towards investments for retirement purposes.
Tax-free death benefits typically are available as lump sum payments from policies; however, complications arise when beneficiaries choose to receive payments in installments or interest. Beneficiaries may avoid additional taxes by opting for lump-sum payout instead; additionally, financial advisors should always be consulted prior to selecting an investment strategy for their lump sum death benefit.
As well as federal estate and inheritance taxes, most states also have laws regarding how life insurance policies and proceeds should be taxed. These rules may apply when an existing policy is transferred between individuals or to businesses entities.
Beneficiaries should consider taxes when selecting and naming beneficiaries of life insurance policies, and having a plan should their primary beneficiary die prior to receiving his/her death benefit payout. An annuity policy could potentially be subject to taxes depending on its terms.
Cash value from whole life policies typically is not subject to taxes; however, in certain instances when surrendered for its value and withdrawn is taxed according to any amount that exceeds their policy’s basis (total premiums paid minus any refunds or dividends).
Let’s imagine Al has purchased a whole life insurance policy since 2012 and has paid $100,000 in premiums so far. He would like to withdraw some cash value for education expenses, but only wants access to $10,000 of his $100,000 current value; since this amount falls under its basis and therefore does not trigger tax liability upon withdrawal; any excess will be subject to tax at his death.
Cash Value
Permanent life insurance policies typically come equipped with a cash value component, acting like a savings or investment account within them. Often this cash value component grows on an interest-deferred basis so you won’t owe taxes when money accumulates annually in it – though you will have to pay taxes when withdrawing or borrowing from it later on.
When surrendering a life insurance policy, its cash value can be collected as a lump sum payment. While this may seem appealing if you need the extra funds quickly, be mindful that there may be fees and tax implications depending on how much of a payment you receive – for instance if surrendering whole life, universal, variable universal policies etc… you may have to pay fees to the insurance company in addition to tax on anything over and above what has been paid in premiums.
Access the cash value in your life insurance policy via loans or partial withdrawals, which are most frequently used to repay debt but can also be used for purposes such as college tuition for your children, down payments on homes and supplementing retirement income. Any cash taken out from a life policy will be taxed at income rates applicable for other sources; however, any excess over its “basis,” or total premium payments, will only require taxes to be withheld from it.
Life insurance policies often include riders that allow you to receive part of your death benefit early if necessary – for instance if you have terminal illness or require long-term care. Most often these accelerated payments are not considered taxable; however it would be wise to consult a tax adviser prior to making any decisions on your policy. It’s also worth remembering that any money taken out from cash value will reduce its death benefit when the time comes for payout; so be cautious if utilizing this feature.
Dividends
Dividends are payments made by insurance companies to policyholders based on their financial performance, which may include expenses, cash flow and investment returns. Dividend payments vary each year based on these factors.
Policyholders can opt to take their dividend in cash or apply it toward future premium payments, which can help lower life insurance premiums while protecting coverage if financial issues arise in the future. Unfortunately, this also reduces death benefits and cash values of their policy as a result.
Policyholders may choose to reinvest the dividend money back into the policy instead of receiving cash or applying it toward premium payments; this option offers higher rates of return while speeding up money growth, but may not be suitable for everyone and can even increase risk.
An alternative solution would be for the insurance company to use its dividend to purchase fully paid additional life insurance policies – often known as paid-up additions (PUA) – without raising premium payments. PUA policies can be added similar to adding riders.
Policyholders also have the option of leaving dividends with their insurance company and investing them in an accumulation account with them, earning interest at a set annual interest rate – though any earnings that accumulate will eventually become taxable income and taxed accordingly.
Policyholders may also withdraw or use their money to pay off outstanding loans, which can save on policy costs while preventing coverage gaps due to unpaid loans. Some insurance companies even provide Overloan Protection Riders which ensure coverage will never lapse regardless of how long an unpaid loan remains outstanding.