Life Insurance Payouts: Are There Limits To Benefits?

Life insurance policies can be sold or surrendered before the death of the insured, and the proceeds are generally subject to taxation. The taxable gain is the exact dollar amount received from selling or surrendering the policy after deducting the premium payments made. While death benefits are typically tax-free, selling or surrendering a policy may trigger capital gains tax. The amount received up to the policy's cost basis (total premiums paid) is usually tax-free, but any excess is taxed as ordinary income or capital gains. Understanding the tax implications is crucial for policyowners considering selling or surrendering their life insurance policies.

Life insurance death benefits are typically tax-free

Instalments vs. Lump Sum

If your loved ones choose to receive the life insurance payout in instalments instead of a lump sum, any interest that builds up on those payments could be taxed as regular income. While the original death benefit is not taxable, the interest is.

Estate Taxes

If a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, this could trigger estate taxes if the estate's total value surpasses the federal estate tax exemption. This typically only affects high-net-worth individuals, but some states have lower thresholds for state estate taxes.

Policy Loans

If there are unpaid loans against the policy, they will be deducted from the death benefit, meaning your beneficiaries will receive less.

Modified Endowment Contracts (MECs)

If the policy is an MEC, taxes are different. Withdrawals are treated as taxable income until they equal all interest earnings in the contract.

Selling a Policy

Selling a life insurance policy, or a life settlement, may trigger income and capital gains taxes. If you sell your policy for more than you paid in premiums, the gain on that amount is usually taxed.

Term Life Insurance Taxation

Term life insurance is generally not taxed because there is no cash value component. However, if the death benefit is paid in instalments, any interest accumulated will be taxed as income.

Permanent Life Insurance Taxation

The tax implications for permanent life insurance can be more complicated due to the cash value component. Withdrawals, policy loans, and dividends can all be taxed.

Withdrawals

If you withdraw more than your cost basis (the total amount of premiums paid), that amount is considered taxable income and must be reported.

Policy Lapses

If your policy lapses due to unpaid premiums or insufficient cash value, any outstanding loan balance that exceeds your cost basis will be treated as taxable income.

Surrendering a Policy

Surrendering a permanent life insurance policy may trigger taxes. If the cash surrender value is higher than the amount of premiums paid, the excess is typically taxed as ordinary income.

Participating Whole Life Policy

While dividends themselves are not taxed, the interest earned on those dividends is considered taxable income and must be reported.

Surrendering a life insurance policy

The process of surrendering a life insurance policy is relatively simple:

• Contact your insurance company to initiate the surrender process. They will guide you through the required steps and documentation.
• Submit the required documentation, which may include a surrender request form.
• Receive the cash surrender value via check or electronic transfer.
• Obtain confirmation of policy termination from your insurance provider.

It's important to note that surrendering a life insurance policy has consequences. Firstly, you will no longer have life insurance coverage, and your beneficiaries will not receive the death benefit upon your death. Secondly, surrendering the policy can result in a financial loss, as the cash surrender value may be lower than the total premiums paid. Additionally, you may be responsible for paying surrender fees and taxes on any gains over the policy's basis or cost.

Before surrendering your life insurance policy, it is recommended to explore alternative options, such as borrowing against the policy, withdrawing from the cash value, or selling the policy through a life settlement. Consulting with a financial advisor can help you make an informed decision that considers your specific circumstances and goals.

Selling a life insurance policy

How to sell your life insurance policy

• Provide the details of your life insurance policy, along with medical records.
• If you’re using a broker, they will shop the policy to potential buyers. Buyers will calculate your life expectancy based on your medical records.
• If you receive an offer, you can sell your policy.
• You will make the buyer the new policy owner, and the buyer will start paying your premiums. It’s possible the buyer could resell the policy to someone else who will pay the premiums.
• You will occasionally have to check in with the buyer to confirm you're still alive.

How much you’ll get depends on your life expectancy, the life insurance face amount, and how much the buyer expects to pay in premiums while you’re alive. The offer is generally more than the cash surrender value of your policy, but less than the death benefit your beneficiaries would receive if you didn’t sell the policy.

Potential pitfalls of life settlements

• It can be tough to determine whether you’re getting a good price for a life settlement.
• The sales commissions involved can eat up as much as 30% of a life settlement.
• You’ll likely have to pay taxes on at least some of the money you receive from a life settlement, while the death benefit of a life insurance policy is usually tax-free for beneficiaries.
• If family members still rely on you financially, they’ll be without the safety net of the life insurance death benefit when you die.
• If you use public assistance, a life settlement could make you ineligible.

What to ask before you sell your life insurance policy

• Do I still need the coverage? If you can afford the premiums and you have beneficiaries who rely on you financially, you’re better off keeping the policy.
• Are there other ways to pay my premium? When life insurance premiums become unmanageable, there are alternatives, such as taking loans from your policy or reducing your death benefit in exchange for lower premiums.
• Can I trust the broker and buyer? Look for a broker who is licensed through your state insurance department, and ask how much of your personal information the buyer will access. Don’t work with a broker or buyer who rushes you into a decision.

How to sell your life insurance policy safely

• Don’t respond to life settlement solicitations. Find a life settlement broker through your financial advisor or life insurance agent.
• Get multiple offers. A life settlement broker can shop your policy around. That way, you have a better understanding of what your policy is worth.
• Research your broker’s license status. It's also worth checking for any complaints against them through your state insurance department.
• Note that you don’t have to sell your policy just because you receive a bid.

Partial withdrawals from a life insurance policy

Here's an example to illustrate this: suppose you've paid a total of $20,000 in premiums into your policy, and it has accumulated a total cash value of $25,000. If you decide to withdraw $23,000, only $3,000 of that amount will be subject to taxation. This is because the portion of the withdrawal that is considered a return of premium, or the amount you've paid in, is typically not taxable.

There may also be additional costs when making a partial withdrawal, such as processing and administrative fees charged by the life insurance company. It's important to be aware of all potential charges before proceeding with any withdrawal.

Withdrawing money from your life insurance policy is just one way to access cash. You can also borrow money through your policy by taking out a life insurance loan, which typically comes with lower interest rates than personal or home equity loans and doesn't impact your credit rating. However, if you choose not to repay the loan, the outstanding balance will be deducted from your death benefit.

Another option is to surrender your policy, which means cancelling it and receiving the surrender value, or the cash value of the policy minus any surrender fees. However, by surrendering your policy, you give up all rights and benefits under that policy, including the death benefit. Additionally, there may be surrender charges to consider, which can be high in the early years of the policy.

Before making any decisions regarding your life insurance policy, it's always recommended to consult with a qualified insurance professional and/or tax professional to discuss all your options and understand the potential tax implications.

Tax implications of capital gains

Life insurance is often exempt from taxes, but there are some situations where taxes may be incurred, particularly on capital gains. Here are the key points to understand:

• Tax-Free Proceeds: Generally, the proceeds from a life insurance policy received by a beneficiary due to the death of the insured are not considered taxable income. This means the beneficiary receives the full amount, free from income tax.
• Interest on Installments: If the beneficiary chooses to receive the life insurance payout in installments instead of a lump sum, any interest that accumulates on those installment payments will be taxed as regular income.
• Estate Taxes: If the life insurance policy owner leaves the death benefit to their estate instead of directly naming a person as the beneficiary, it may trigger estate taxes if the estate's total value exceeds the federal estate tax exemption.
• Selling a Policy: Selling a life insurance policy, known as a life settlement, can trigger income and capital gains taxes. The portion of the sale amount exceeding the total premiums paid (cost basis) may be subject to income tax, and any amount above the policy's cash surrender value may be taxed as capital gains.
• Modified Endowment Contracts (MECs): If a life insurance policy is classified as an MEC, withdrawals are taxed differently. Withdrawals are treated as taxable income until they equal all interest earnings in the contract.
• Capital Gains Tax on Life Settlements: When selling a life insurance policy, proceeds above the policy's cash surrender value are typically taxed as capital gains. This is based on the profit made from the sale, such as the amount received above the policy's cash value.
• State-Specific Considerations: Some states have their own regulations and tax laws regarding the taxation of life settlement proceeds, which can vary widely and impact factors such as tax treatment, exemptions, and reporting requirements.
• Chronically or Terminally Ill Individuals: In certain circumstances, the sale of a life insurance policy by someone who is chronically or terminally ill may be entirely free from income tax. This is because the sale proceeds are treated as if the life insurance company paid the death benefit, which is usually not taxable.
• Ordinary Income Tax: Proceeds from a life insurance policy sale that are above the total premiums paid (cost basis) but below the policy's cash surrender value may be taxed as ordinary income.

Frequently asked questions