In most situations, life insurance proceeds aren’t taxable, but there are select occurrences where that is not the case. Your life insurance policy will be your financial legacy you leave for your family. In most cases, your loved ones will receive the entire amount available from your policy.
There are, however, specific circumstances in which life insurance benefits can be taxed – generally related to permanent life insurance policies, like whole life, or those who leave behind tremendous assets.
One of the major benefits to life insurance is that the majority of cases do not allow for the payouts to be taxed, such as in these circumstances:
- Cash value gains: Permanent life insurance policies build cash value over time, which your beneficiaries receive in addition to the policy payout. No income tax is taken from that cash value.
- Dividends: If mutual insurance companies – companies owned by policyholders – receive dividends each year, that money isn’t taxable as long as it’s not more than you’ve paid in premiums.
- Payouts to beneficiaries: The reason life insurance is so important is to ensure your beneficiaries are taken care of financially if you’re not around to do so. Beneficiaries typically do not pay taxes on the cash they receive (rare instances may change this as described below).
- Payouts to spouses: Even if your estate if large enough to be taxed, your spouse is excluded from estate taxes.
- Surrender payouts: In the event you decide you no longer want your life insurance policy, you “surrender” it and get the cash. Taxes aren’t taken out unless you get more in the surrender payout than what you paid in.
When Is Life Insurance Taxable?
- Estate taxes on life insurance payouts: If you leave an estate large enough to be taxed, your life insurance payout may be considered part of your estate – which makes it taxable. The estate tax is used for estates valued at $5.49 million in 2017, according to the IRS. To avoid the tax, some will transfer the policy to an irrevocable trust. It’s important to note that if the policy is transferred less than three years before being cashed out, the money can still be taxed.
- Interest on payouts: If your policy beneficiaries choose to take the payout in installments rather than one lump sum, the insurance company would pay interest on the balance, and that interest is taxable.
- Profit from life insurance settlements: Any proceeds you get from a life insurance settlement could be taxable. A life insurance settlement involves selling your policy to someone else, they take over the premium payments, and receive the money in the event of your passing. The amount taxed depends on the policy type, cash value, and amount paid into the policy.
- Revenue from surrendering a cash value policy: If you “surrender” a life insurance policy and you’re payout is more than what you put into the policy over time, you will owe taxes on the overage.
- Unpaid loans against your policy: If you borrow again the cash value of a permanent life insurance policy, you must pay the money back, plus interest. You’ll owe taxes on any loan balance if you surrender the policy or it lapses.