Life Insurance: Income Or Asset?

Life insurance is often seen as a way to provide financial security for loved ones after you're gone. But is it taxable? In most cases, life insurance proceeds are not considered taxable income. However, there are some exceptions to this rule. For example, if the payout is structured as multiple payments over time, any interest accrued may be subject to taxes. Similarly, if the policyholder withdraws or takes out a loan against the policy's cash value, and the amount exceeds the total premiums paid, the excess may be taxable. It's important to carefully review the specifics of your policy and consult a tax professional to understand the tax implications and avoid any unexpected complications.

Interest on life insurance payouts is taxable income

Life insurance payouts are generally not considered taxable income and can be a great way to provide for your loved ones after you're gone. However, interest on life insurance payouts is taxable income, and there are some other exceptions where taxes could come into play.

Interest on Installments

If your beneficiaries choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments is considered taxable income. This means that while the original death benefit is not taxed, the interest accrued is taxed as regular income.

Estate Taxes

If the life insurance policy goes into your estate instead of directly naming a person as the beneficiary, it could be subject to estate taxes if the total value exceeds certain thresholds. According to the IRS, if the life insurance proceeds included in the estate, together with the estate's value, exceed the federal estate tax threshold of $12.92 million as of 2023, estate taxes must be paid on the amount over the limit. Some states also have lower estate tax thresholds or assess inheritance taxes.

Policy Loans or Withdrawals

Whole life insurance policies allow policyholders to borrow or withdraw money from the policy's cash value. If the amount withdrawn or loaned exceeds the total amount of premiums paid, that excess may be subject to income taxes. Additionally, if there are unpaid loans against the policy when it is terminated or surrendered, the loan amount exceeding the cumulative premiums may also be taxed as income.

Surrendering or Selling the Policy

If you surrender or sell your life insurance policy, any funds you receive over the policy's cash basis or the cumulative premiums paid will be taxed as regular income.

While life insurance proceeds are generally not taxable, it's important to be aware of these exceptions to avoid unexpected tax complications. Regularly reviewing your policy and consulting with a tax professional can help you stay informed about potential tax liabilities and ensure your beneficiaries receive the full benefit.

Death benefits paid to the estate may be taxed

In the United States, death benefits from life insurance policies are not subject to ordinary income tax. However, if the beneficiary receives the death benefit in installments that include interest, then the interest will be taxable.

Withdrawing more than your premium payments may be taxed

Life insurance is often exempt from taxes, but there are some instances where taxes may apply. One such case is when the policyholder withdraws more money than they have paid in premiums. While the amount withdrawn up to the cost basis is typically tax-free, any excess may be considered taxable income.

For example, if a policyholder has paid $50,000 in premiums and their policy has a cash value of $80,000, withdrawing the full $80,000 would result in $30,000 being considered taxable income. This is because the withdrawal amount exceeds the total amount of premiums paid.

Similarly, if a policyholder takes out a loan against their policy's cash value and the policy lapses or is surrendered, any outstanding loan balance above the cost basis will be treated as taxable income. In this scenario, taxes may be owed on the difference between the loan amount and the total premiums paid.

It is important to note that the specific tax implications can vary depending on the type of life insurance policy, the location, and other factors. Consulting with a tax professional is always recommended to understand the tax consequences of any withdrawals or loans against a life insurance policy.

Additionally, careful planning and consideration can help mitigate potential tax liabilities. Strategies such as choosing a lump-sum payout, using an irrevocable life insurance trust, and regularly reviewing beneficiaries can minimize the chances of unexpected tax burdens for beneficiaries.

Surrendering a policy may be taxed

Surrendering a life insurance policy may be taxed depending on the cash value of the policy. If the cash value of the policy is higher than the amount of premiums paid into the policy (your cost basis), the excess is typically taxed as regular income. This means that the amount you receive on surrendering your policy may be subject to income tax if it is more than you paid into the policy.

For example, if you have paid $30,000 in premiums and the cash surrender value of the policy is $45,000, the difference of $15,000 would be taxed as ordinary income. This could push you into a higher tax bracket for that year.

It is important to note that the rules around taxation of life insurance policies vary depending on the type of policy and the location. Therefore, it is always recommended to consult a tax professional for specific advice regarding your individual circumstances.

Selling a policy may be taxed

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

• The portion of the sale amount 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 continue to pay.

It's important to note that viatical settlements for the terminally ill may escape this tax. A viatical settlement allows you to invest in and purchase a life insurance policy worth less than the death benefit. Whether or not the sale is taxable depends on how much the policy is sold for compared to how much has been paid into it.

Frequently asked questions