Life Insurance Paid Add-Ons: Taxable Or Not?

Life insurance is a financial product that provides a lump-sum payout, known as a death benefit, to beneficiaries upon the insured's death. While life insurance proceeds are typically tax-free, certain situations can trigger tax liabilities. For instance, if the beneficiary receives the payout in installments, any accrued interest becomes taxable income. Additionally, if the beneficiary is an estate, the death benefit may be subject to estate taxes. Withdrawals or loans from the policy's cash value that exceed the total premiums paid can also be taxed. Understanding these tax implications is crucial when making decisions regarding life insurance policies.

Withdrawing money from the cash value

Understanding Cash Value

Before withdrawing money, it's important to know that not all life insurance policies have a cash value component. Term life insurance policies, for instance, do not accumulate cash value. Permanent life insurance policies, such as whole life and universal life, are the ones that typically build up cash value over time.

Timing of Withdrawals

The timing of withdrawals is crucial. Many life insurance policies do not allow withdrawals within the first two years. Additionally, early withdrawal fees may apply during the initial years of the policy to encourage long-term investments. It's important to review the terms of your specific policy to understand any applicable restrictions or fees.

Tax Implications of Withdrawals

The tax consequences of withdrawing money from the cash value of your life insurance policy depend on several factors. Here are some key considerations:

• Withdrawals up to the amount you have paid in premiums are generally not considered taxable income.
• Withdrawing more than the amount you've paid in premiums may result in taxable income. Any earnings above the cost basis may be subject to income tax.
• If your policy is a Modified Endowment Contract (MEC), withdrawals are treated differently for tax purposes. Withdrawals from a MEC are taxed as earnings first, followed by a return of the policy's cost basis.
• Withdrawals will typically reduce your death benefit. This reduction may be greater than the amount you withdraw, depending on the terms of your policy.
• Withdrawals may also negatively impact the growth of your cash value account.

Alternatives to Withdrawals

Before opting for a withdrawal, consider other alternatives available to access funds from your life insurance policy:

• Borrow against your policy: You can take a loan from your insurance provider, using your policy as collateral. This option allows you to keep your policy intact, but you will need to repay the loan, typically with interest.
• Surrender your policy: If you no longer need the coverage, you can cancel your policy and receive a surrender cash value payment. This option provides a lump sum payment but comes with surrender fees and taxes, and your beneficiaries will not receive a death benefit.
• Sell your policy: You may be able to sell your policy to a life settlement company or through a viatical settlement. This option provides a lump sum payment, but your heirs will not receive a death benefit, and you may owe taxes on the sale.

Seek Professional Advice

Consulting a financial advisor or tax professional is highly recommended before making any decisions regarding your life insurance policy. They can help you understand the specific terms, conditions, and tax implications of withdrawing money from the cash value of your policy.

Surrendering the policy

Surrendering a life insurance policy is a way to get money back from it. It involves cancelling your life insurance and receiving the cash surrender value from your insurance company. This is the money a policyholder receives for ending their coverage before the policy's maturity date or their death, minus any surrender fees and taxes on earnings.

Pros of Surrendering a Life Insurance Policy

• It's a simple and quick process.
• You'll get some money back, which is better than getting nothing if you let the policy lapse.

Cons of Surrendering a Life Insurance Policy

• You'll only get one offer from the insurance company, and it will be a low-ball offer.
• There are surrender fees, which can be up to 35% of the proceeds and are usually highest in the early years of the policy.
• You'll lose coverage and will have to replace the policy if you still need it.

When to Surrender a Life Insurance Policy

• When you no longer need coverage, e.g. your children are grown up and independent.
• When the costs are too high.
• When you've found a better policy.
• When you urgently need cash.

How to Surrender a Life Insurance Policy

To surrender your life insurance policy, you just need to tell your insurance company that you'd like to surrender and let them work out the details of your policy to determine the cash surrender value you'll get back.

Taxes on Surrendering a Life Insurance Policy

You will only need to pay taxes on amounts that exceed the total amount of premiums paid into the policy. The gain on your policy will be taxed as income. Consult a tax professional for advice on your specific circumstances.

Employer-paid group life insurance

Group life insurance is a type of insurance offered by an employer or another large-scale entity, such as a labour organisation, as a benefit to its workers or members. It is typically inexpensive, and sometimes free, as the cost is shared among the group members.

Group life insurance is a single contract that covers a group of people. Companies are able to secure lower costs for each individual employee by purchasing coverage through an insurance provider on a wholesale basis. This means that group life insurance is often a good deal for employees, who may pay very little or nothing at all for their coverage.

However, this type of insurance usually only offers basic coverage. Death benefits are generally limited to $20,000, $50,000, or one to two times the insured's annual salary. This is why experts recommend that group life insurance be supplemented with a separate individual policy.

Another potential drawback is that the employer controls the policy. This means that your premiums can increase based on decisions made by your employer. If your employer decides to stop offering group life insurance, or if you leave your job, your coverage will usually stop. However, you may have the option to continue coverage at the individual level, which means the policy is converted from a group life policy to an individual one. This will come with higher premiums, but it can be a good option for those who are otherwise uninsurable, as a medical exam is not required.

Taxation of group life insurance

If your employer pays for your coverage, the premiums for coverage over $50,000 may be subject to income tax. The first $50,000 worth of coverage is tax-free.

Pros and cons of employer-paid group life insurance

Pros

• Convenience: Getting coverage through work is relatively simple, as the paperwork is often part of your hiring documents, and HR departments are on hand to answer questions.
• Price: Basic coverage through work is usually free or offered at a low cost, making it an easy way to get a small amount of coverage.
• Acceptance: Most basic life insurance plans through work are guaranteed, so even people with serious medical conditions can qualify.

Cons

• Coverage is tied to your job: Group life insurance is often not portable, meaning that if you leave your job, you may not be able to take the policy with you.
• Limited choice: Coverage through work is usually a type of term life insurance, and employers typically only work with one carrier, so you won't find the same range of policy options that you would on the open market.
• Low coverage amounts: If you have dependents or a lot of financial obligations, a group life insurance policy might not provide enough coverage.
• Premiums aren't fixed: The premiums for group life insurance tend to increase annually or every five years.

Payment in installments

Life insurance proceeds are generally not taxable if you are the beneficiary and are receiving them due to the death of the insured person. However, there are certain situations where taxes may be applicable. One such scenario is when the beneficiary chooses to receive the life insurance payout in installments instead of a lump sum.

If the death benefit from a life insurance policy is paid out in installments, any interest that accumulates on those payments will be taxed as regular income. This means that while the death benefit itself is typically not taxed, the extra money from interest is considered taxable income. Therefore, if the payout is spread out over time, the beneficiary should be prepared to report and pay taxes on the interest portion.

To avoid this tax implication, beneficiaries may opt for a lump-sum payout, which keeps the entire death benefit income tax-free. It is important to carefully consider the options and seek professional advice to make an informed decision regarding the payout structure.

The beneficiary is an estate

When a death benefit is paid to an estate, the person or persons inheriting the estate may have to pay estate taxes. This is because the proceeds are included in the estate's gross value and could be subject to exceptionally high estate taxes.

To avoid this, the policyholder can transfer ownership of the policy to another person or entity. This must be done at least three years before death, as the IRS treats any gifts of life insurance policies made within three years of death as subject to federal estate tax.

Another way to avoid estate taxes is to create an irrevocable life insurance trust (ILIT). The policy is held in trust, and the proceeds are not included as part of the estate.

Frequently asked questions