Insurance Payouts: Income Or Not?

Life insurance payouts are generally not considered income and are not subject to income taxes or estate taxes. However, there are certain exceptions where proceeds from a policy can be taxable. For example, if the payout is in the form of installments, the interest accrued will be taxable. If the policy is surrendered, and the surrender proceeds exceed the cumulative premiums, the excess may be subject to income taxes. Additionally, if the policy is included as part of the deceased's estate, and the total value exceeds the federal estate tax threshold, estate taxes must be paid on the amount over the limit. It is important to consult a financial advisor or tax professional to understand the specific tax implications for your situation.

Proceeds from term, whole, or universal life insurance

Term Life Insurance

Term life insurance is the simplest type of life insurance, providing coverage for a specific period, such as 10, 20, or 30 years. It is also the most affordable option, with lower premiums compared to whole and universal life insurance. Term life insurance does not accumulate cash value, and its coverage is limited to the term of the policy. If the insured passes away during the policy term, the beneficiaries receive the death benefit. However, if the policy expires and is not renewed, the beneficiaries will not receive any payout.

Whole Life Insurance

Whole life insurance, on the other hand, provides coverage for the insured's entire life. It has two components: a death benefit and a cash value component. A portion of the premiums goes towards the death benefit, while the other portion accumulates cash value, which can be accessed by the policyholder. Whole life insurance offers fixed and guaranteed premiums, death benefits, and cash value growth, making it a stable and predictable option. However, the premiums tend to be significantly higher than those of term life insurance.

Universal Life Insurance

Universal life insurance is another type of permanent life insurance that offers flexibility. It allows the policyholder to adjust the premiums and death benefit within certain limits. Universal life insurance may have flexible or fixed premiums, depending on the specific policy. The cash value growth of universal life insurance varies depending on the type of policy chosen, such as guaranteed, indexed, or variable universal life insurance. While universal life insurance provides flexibility, it may have higher costs and complexity compared to term life insurance.

Taxation of Proceeds

While the proceeds from term, whole, or universal life insurance are generally not considered taxable income for the beneficiaries, there are certain exceptions. If the proceeds are paid in multiple installments, the payments may be subject to taxes. Additionally, if the policyholder has withdrawn money or taken out a loan against the policy, exceeding the total amount of premiums paid, the excess may be taxable. In the case of employer-paid group life insurance, if the payout exceeds a certain threshold, it may also be taxable. Lastly, if the life insurance proceeds are included in the deceased's estate, and the total value exceeds the federal estate tax threshold, estate taxes may need to be paid on the amount above the limit.

When proceeds are paid in a lump sum

When insurance proceeds are paid in a lump sum, they are generally not considered taxable income. This is true for term, whole, and universal life insurance policies. However, there are some exceptions. For example, if the payout exceeds the federal estate tax threshold of $12.92 million (as of 2023), estate taxes must be paid on the amount over the limit. In addition, if the policy has no named beneficiaries, the proceeds may be included in the deceased's estate, and if the value exceeds the federal estate tax threshold, estate taxes must be paid on the excess.

Lump-sum payments offer the beneficiary the most flexibility in how they use the money. However, receiving a large amount of money at once can be overwhelming, and the beneficiary is responsible for making it last. If the payout is large, it may need to be split across multiple accounts as Federal Deposit Insurance Corp. deposit insurance covers only $250,000 per depositor, per FDIC-insured bank.

When proceeds are paid in multiple payments

When insurance proceeds are paid in multiple payments, it is known as an annuity. This is when the beneficiary chooses to receive their payout in a series of payments over several years instead of a lump sum.

In this case, the interest accrued by the annuity account may be subject to taxes. The payments include proceeds and interest, and these payments can be subject to taxes.

For example, if you withdraw more money from your policy than you have paid in premiums, you may have to pay income taxes on the excess. This is because the money withdrawn or loaned in excess of the total amount of premiums paid is considered taxable income.

If you borrow against the cash value of your policy and the loan is still outstanding when the policy is terminated or surrendered, the loan amount in excess of the cumulative premiums may be subject to income taxes.

It is important to note that the taxation of insurance proceeds can vary depending on the type of insurance, the location, and other factors. It is always recommended to consult with a tax professional to understand the specific tax implications for your situation.

When the policyholder has withdrawn money or taken out a loan

When it comes to life insurance, there are certain scenarios where the policyholder withdrawing money or taking out a loan may result in taxable income. Here are some key considerations:

• Whole Life Insurance: Whole life insurance policies can accumulate cash value over time, allowing policyholders to withdraw money or take out loans against the policy's cash value. If the policyholder withdraws more than their cumulative premium payments, the excess amount may be subject to income taxes.
• Surrendering the Policy: If a policyholder surrenders their whole life insurance policy, they can exchange it for a cash payment from the insurance company. If the surrender proceeds exceed the cumulative premiums paid, the excess amount may be subject to income taxes.
• Outstanding Loans at Policy Termination: If a policyholder takes out a loan against the cash value of their whole life policy and the loan is still outstanding when the policy is terminated or surrendered, the loan amount that exceeds the cumulative premiums may be subject to income taxes.
• Interest Income: Any interest income earned on the cash value of a life insurance policy is generally considered taxable income and must be reported as such.
• Modified Endowment Contracts (MEC): If a life insurance policy is classified as a MEC, it receives less favourable tax treatment. In this case, policy loans, distributions, and gains may be subject to income taxes.
• Employer-Paid Group Life Insurance: According to the Internal Revenue Service (IRS), if employer-paid group life insurance coverage exceeds $50,000, the premiums paid by the employer for coverage over $50,000 are subject to income taxes.
• Estate and Inheritance Taxes: If the life insurance proceeds are included in the deceased's estate and the total value exceeds certain thresholds, estate and/or inheritance taxes may apply. These taxes are determined by federal and state regulations.

It is important to consult with a tax professional or financial advisor to understand the specific tax implications of withdrawing money or taking out a loan against a life insurance policy, as the rules can vary depending on the type of policy, location, and other factors.

When the policyholder surrenders their policy

When a policyholder surrenders their life insurance policy, they end their life insurance contract and forfeit their right to the death benefit. This means that their heirs will no longer receive a payout when the policyholder passes away. Surrendering a policy is often done when it is no longer needed or wanted, or when the premium becomes too high.

There are two types of surrender values: guaranteed surrender value and special surrender value. The guaranteed surrender value is calculated as a percentage of the premium paid up until the policy is surrendered, excluding the first year's premium and any rider premium. The special surrender value is calculated based on the sum assured, accrued bonuses (if any), policy term, and total premiums paid so far.

The process of surrendering a policy will vary depending on the insurance company, and there may be surrender charges or fees involved. These fees are typically higher in the early years of a policy and gradually decrease over time. Surrender fees can range from 10% to 35% of the policy's cash value and usually last for 10 to 15 years. It's important to review the policy documents carefully to understand the fees and charges associated with surrendering.

When a policy is surrendered, the policyholder will receive the cash surrender value, which is the total accumulated cash value minus any prior withdrawals, outstanding loans, and surrender charges. The cash surrender value is considered a tax-free return of the principal of the premiums paid. However, if the cash surrender value exceeds the total amount of premiums paid, the excess amount may be taxed as regular income.

It's important to note that surrendering a life insurance policy may result in a loss of benefits and coverage, and it could be more advantageous to explore other options such as taking out a loan against the policy or selling it through a life settlement. Selling a policy can often result in a higher payout compared to surrendering it.

Frequently asked questions