Life Insurance Annual Interest: Taxable Or Not?

Life insurance is a financial safety net that ensures your family is provided for in the event of your death. But are life insurance proceeds taxable?

In most cases, life insurance proceeds are not taxable. However, there are some exceptions. For example, if your beneficiary chooses to receive the payout in installments, they will have to pay income tax on the interest accrued. Similarly, if the policy is owned by a third party, your beneficiary may have to pay taxes on the proceeds.

Another exception is if the death benefit becomes part of your estate. If the total value of your estate exceeds the federal estate tax exemption limit, currently $13.6 million for an individual, your heirs might be charged estate taxes.

It's important to understand how and when these taxes apply to avoid any surprises. While life insurance provides peace of mind, careful planning is necessary to ensure your beneficiaries receive the full benefit.

Instalments to beneficiaries may accrue interest, which is taxable

Parents often request to have their life insurance death benefit paid in instalments if their beneficiary is a young child or someone dependent on their income. In these cases, the beneficiary would have to pay income tax on the interest. While the beneficiary will not pay taxes on the benefit itself, they will be responsible for paying income taxes on any interest accrued.

For example, if a beneficiary receives a $500,000 death benefit that earns 10% interest for one year before being paid out, they will owe income taxes on the $50,000 in interest growth.

The death benefit is typically paid out in a lump sum, but the life insurance beneficiary may be able to elect to receive the payout in instalments, otherwise known as an annuity. If this happens, the insurer typically holds the principal amount in an interest-bearing account and issues a percentage of the death benefit over a set number of years. While instalments provide a steady income stream, the interest that accumulates on the death benefit is subject to income tax. The original life insurance death benefit typically isn't, though.

Interest on dividends from participating whole life insurance policies is taxable

Dividends from life insurance policies are treated as tax-free returns of premiums. However, if you are earning interest on those dividends, the interest gained is taxable. Dividends are considered a return of a portion of the premiums paid for a life insurance policy. The insurance company invests the premium payments, and if the company keeps expenses down and its investments do well, it declares a dividend, returning a portion of the surplus to policyholders.

The dividend amount often depends on the amount paid into the policy. For example, a policy worth $50,000 that offers a 3% dividend will pay a policyholder $1,500 for the year. If the policyholder contributes an additional $2,000 in value during the subsequent year, they will receive $60 more for a total of $1,560 the following year. These amounts can increase over time, potentially offsetting some costs associated with premium payments.

Whole life insurance dividends may be guaranteed or non-guaranteed depending on the policy, so it is important to carefully read through the plan's details before purchasing a policy. Policies that provide guaranteed dividends often have higher premiums to make up for the added risk to the insurance company. Those that offer non-guaranteed dividends may have lower premiums, but there is a risk that no dividends will be paid in a given year.

When it comes to using policy dividends, there are several options:

• Cash or check: The policyholder may request that the insurer send a check for the dividend amount.
• Premium deductions: The policyholder can request that the dividend goes towards future premiums to offset the cost.
• Additional insurance: The policyholder may use the dividend amount to purchase additional insurance or prepay on their policy.
• Savings account: The policyholder may decide to keep the dividend with the insurance company to earn interest on the amount.

Surrendering a policy may result in a taxable excess of cash value

Surrendering a life insurance policy may result in a taxable excess of cash value. This taxable event occurs when the cash value of the policy is greater than the amount paid in premiums. In other words, if you receive more money than you put into the policy, you may be taxed on the difference. This is because the Internal Revenue Service (IRS) considers the surrender of a life insurance policy a taxable event if the surrender value exceeds the premiums paid.

When you surrender a life insurance policy, you are essentially cancelling the policy to receive the cash surrender value. The cash surrender value is the amount you receive when you surrender the policy, which is based on the policy's cash value. The cash value is the component of a permanent life insurance policy that accumulates cash through regular premium payments. It is important to note that term life insurance policies do not have a cash value, so there is no surrender value if you cancel the policy.

If you surrender a policy with a cash value greater than the amount of premiums paid, the difference between the cash surrender value and the total premiums paid is considered taxable income. The amount of tax you owe will depend on your marginal tax rate for the year, or your income tax bracket. The IRS taxes this income at the federal level, typically between 10% and 37%, depending on your income level.

In addition to the potential tax consequences, there may also be surrender fees or charges deducted from the cash value if you surrender the policy before a specified number of years, usually around ten. These fees can reduce the amount of taxable gain, but they are not deductible on your tax return.

If you have an outstanding loan against the cash value of your policy, the insurance company will deduct the loan amount and any interest from the cash surrender value. This may reduce the amount of taxable gain and, by extension, the amount of income tax you owe.

Before surrendering a life insurance policy, it is important to consider the potential tax implications and consult with a tax advisor or financial advisor to understand the specific tax consequences for your situation. There may be alternative options to access cash from your policy, such as borrowing against the policy or selling the policy, that could result in a larger cash payment.

Policy lapses with outstanding loans may trigger taxable income

For example, if you have paid $100,000 in premiums over 10 years and taken out loans totalling $125,000, you will have a taxable event when the policy lapses. You will need to include $25,000 ($125,000 - $100,000) plus accrued interest in your income. This is because the taxable gain is calculated based on the full cash value before loan repayment. So, even if all of a policy's cash value is used to repay a life insurance loan, the taxes are still due on the gain itself.

In some cases, a life insurance policy tax bomb is triggered simply by the policyholder stopping payment of premiums. This is especially common with whole life insurance policies, where it is a requirement to pay the premium every year. If the policyholder stops paying premiums, the policy will remain in force, but only because the insurance company takes out a loan on behalf of the policyholder to pay the premium. Over time, years of unpaid premiums lead to years of additional loans, plus accruing loan interest, which can cause the policy to lapse.

The "tax bomb" can be avoided by holding the life insurance policy until death, allowing the loan to be repaid from the tax-free death benefit. However, this may not be affordable or economically feasible for the policyholder.

Selling a policy may result in income and capital gains taxes

Selling a life insurance policy, also known as a life settlement, may result in income and capital gains taxes. If you sell your policy for more than what you've paid in premiums, the gain on that amount could be taxed. Here is a breakdown of how the taxation of life insurance policy sales works:

• The portion of the sale amount that is equal to what you've paid in premiums (your "cost basis") will not be taxed.
• The portion that exceeds your cost basis but is less than the cash value of the policy is subject to income tax.
• Any amount above the cash value is subject to capital gains tax.

Additionally, the new owner of the policy may face taxes on any death benefit they receive that exceeds what they paid for the policy, plus any premiums they've continued to pay.

It's important to note that the tax implications of selling a life insurance policy can be complex, and specific situations may vary. It's always a good idea to consult with a tax professional or financial advisor for personalized advice.

Frequently asked questions