Life Insurance Benefits: Taxable Or Not?

Life insurance benefits are typically not taxed, but there are some circumstances in which they can be. For example, if the beneficiary chooses to receive the payout in installments, any interest that builds up will be taxed as regular income. Additionally, if the policyholder leaves the death benefit to their estate instead of naming a person as the beneficiary, estate taxes may be triggered. Withdrawing more than the cost basis from a cash value life insurance policy can also trigger taxes. It's important to carefully review your policy and plan ahead to avoid unexpected tax complications.

Interest on life insurance proceeds is taxable

Life insurance proceeds are generally not taxable if you are the beneficiary receiving them due to the death of the insured person. However, any interest received on the proceeds is taxable and must be reported as interest income. This means that if you choose to receive the life insurance payout in installments instead of a lump sum, any interest that accumulates on those payments will be taxed as regular income. This is because the interest is considered taxable income, even though the original death benefit is not.

For example, let's say you are the beneficiary of a life insurance policy and you choose to receive the death benefit in installments. Over time, interest will accumulate on those installment payments. This interest is considered taxable income, and you will need to report it on your tax return. The death benefit itself is typically not taxed, but the interest that builds up on those payments will be.

It is important to note that there may be other exceptions or considerations when it comes to life insurance taxation. For instance, if the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds may be limited. Additionally, if the policy is a modified endowment contract (MEC), there are different tax rules that apply. It is always a good idea to consult with a tax professional to understand the specific tax implications of your life insurance policy.

Naming your estate as beneficiary may trigger taxes

Naming your estate as the beneficiary of your life insurance policy may trigger taxes. This is because, in this case, the death benefit becomes part of your taxable estate. If the value of your estate is large enough, it may trigger estate taxes, reducing the amount your loved ones ultimately receive.

In the US, the federal estate tax exemption was $13.61 million in 2024. However, some states have a state estate tax, which typically has a lower threshold. Therefore, it is important to factor this into your planning and work with an estate planner to minimise tax implications.

If you name your estate as the beneficiary and die without a will, the court will appoint someone to administer your estate, delaying the payment of your pension benefit. This can also result in higher estate administration costs, such as probate fees and legal fees.

Additionally, naming your estate as the beneficiary can lead to potential challenges from disgruntled heirs. Challenges to a will could be more likely to be successful than a direct named beneficiary.

To avoid these potential tax implications and ensure your loved ones receive as much of the death benefit as possible, it is recommended to name a specific individual or individuals as beneficiaries.

Naming a third-party beneficiary may result in taxation

Life insurance death benefits are typically tax-free, but there are exceptions. One such exception is when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary.

In such cases, the death benefit becomes part of the taxable estate. If the estate's total value surpasses the federal estate tax exemption, estate taxes may be triggered, reducing the amount that your loved ones ultimately receive.

To avoid this, it is important to regularly review your policy and ensure that your beneficiary designations are up-to-date. Naming a third-party beneficiary, such as a person who was not originally a party to the contract, can help prevent estate taxes.

It is worth noting that, while life insurance proceeds are generally not considered taxable income, any interest received is taxable and should be reported.

Withdrawing money from a cash value life insurance policy

Withdrawing from a Cash Value Life Insurance Policy

However, withdrawing more than your basis may result in taxable ordinary income. Withdrawing earnings may trigger income taxes at your regular income tax rate. It is important to note that withdrawals will also reduce the death benefit, so your beneficiaries will receive a smaller payout.

Loans from a Cash Value Life Insurance Policy

Another option for accessing cash from your life insurance policy is to take out a loan. This allows you to borrow money from the policy, which you can choose to pay back with interest or have the amount deducted from the death benefit. Loans from a life insurance policy are completely tax-free, as long as they are not borrowed from a modified endowment contract. There is no need to repay the loan amount, but if you don't, the loan and interest will be subtracted from the death benefit.

Interest rates on policy loans are typically lower than other loan options, but it is important to be aware that the amount owed will grow over time due to these interest charges. Additionally, if the loan amount and interest reach the total cash value of the policy, the policy can lapse.

Surrendering a Cash Value Life Insurance Policy

If you are willing to end your life insurance policy, you can surrender it and receive the full cash value, minus any surrender or cancellation fees. However, this option comes with tax implications. You will likely have to pay taxes on any gains or earnings on the cash value portion of the policy. Additionally, by surrendering the policy, you give up your life insurance coverage, so your beneficiaries will not receive a death benefit.

Selling a Cash Value Life Insurance Policy

Selling your life insurance policy is another way to access cash. This involves selling the policy to a third party for a lump sum that is greater than the cash value but less than the death benefit. The buyer then takes over premium payments and receives the death benefit when you pass away.

Selling your policy can provide a larger cash payout than surrendering it, but there are restrictions and qualifications to consider. You may need to meet certain age or health requirements, and there may be fees and income taxes associated with the sale.

Pros and Cons of Withdrawing from a Cash Value Life Insurance Policy

Withdrawing cash from a life insurance policy offers quick access to funds, but it is important to weigh the advantages and disadvantages.

Pros:

• No interest is paid on a withdrawal.
• You can withdraw up to the amount of your basis tax-free.

Cons:

• Withdrawals reduce the policy's cash value and death benefit.
• Withdrawals may be taxable if they exceed the amount of premiums paid.
• Beneficiaries will receive a reduced death benefit.

In conclusion, withdrawing money from a cash value life insurance policy can provide a financial safety net while you are alive. However, it is important to carefully consider the potential tax implications and the impact on your death benefit. Consulting a financial advisor can help you understand the consequences of accessing your cash value and make an informed decision.

Surrendering a life insurance policy

Whole and universal policies

Whole and universal policies accrue cash value, making them the most likely option for surrender. Depending on the type and age of the policy, they may have accrued a significant amount of cash value. The cash surrender value of these policies is the cash value minus any surrender fees.

Term life insurance policies

Term life insurance policies typically have no cash surrender value. Surrendering a term policy essentially means removing the monthly premium from your budget, but you won't receive a payout.

Tax implications

The cash received from surrendering a life insurance policy is taxable as ordinary income. If you receive a payout from investments in the policy that is greater than the policy's cash value assigned by the insurer, that will be taxed as capital gains. Consult a tax professional for advice.

Frequently asked questions