Is Life Insurance Taxable? Is the death benefit taxable? These are some common questions asked when it comes to life insurance and taxes.
Most beneficiaries want to know these answers upon the receipt of the proceeds of a life insurance policy.
This is because having to hand over even a portion of what is received from a death benefit can make a big difference in the future financial well-being of an insured’s loved ones.
The good news is that life insurance proceeds are usually not taxable – at least from an income tax standpoint. This means that the beneficiary of a policy will not have to report these funds on his or her income tax return.
There are, however, some instances where life insurance proceeds could be subject to taxation. So, it is important to know when this is the case, as well as how much of the proceeds could be considered taxable.
How Life Insurance Proceeds Can Be Received
As the beneficiary of a life policy, you will typically have several different options in how you receive the proceeds. In most cases, beneficiaries will take their proceeds in just one, single lump sum. In this case, the money will not be subject to income taxation.
If you choose a different type of life insurance settlement option, then some of the proceeds that you receive could be subject to taxation. For instance, you may have one or all of the alternate options for taking a policy settlement:
If you opt for the life income option, the way that you receive the proceeds will be similar to the income stream that is received from an annuity.
In this case, you will be guaranteed to continue receiving regular income payments for the remainder of your life, regardless of how long that is. Here, each of your income payments will include some initial principal and some gain.
So, a portion of your income payment will be taxable – which is the portion that represents a gain – and a portion will be income-tax free (which is the portion of the income payment that represents the initial principal. In this case, the principal would be the initial amount of death benefit proceeds that the income is based on).
If you choose the interest income settlement option, the company would retain the death benefit proceeds, and then pay you interest on these proceeds.
You may be able to choose your income payment to arrive monthly, quarterly, semi-annually, or annually. As the interest is considered to be gain, it will be taxable to you. (When choosing this option, you can typically withdraw some or all of the initial death benefit proceeds. These funds will not be taxable as income to you).
As the name implies, if you choose a specific income policy settlement option, you will receive an equal dollar amount of income each year until all of the proceeds from the policy’s death benefit have been paid out.
Fixed Period / Fixed Amount
Many carriers will also allow beneficiaries to choose the fixed period / fixed amount settlement option.
With the fixed period option, you will receive an amount of both principal and interest throughout a set time period. If the primary beneficiary dies before all of the money has been paid out, then the remainder of the funds will be paid out to a contingent beneficiary.
If you choose to go with a fixed amount life insurance settlement option, then the policy’s proceeds will be paid out in a set amount over time until the principal and interest are completely exhausted. In this case, though, the beneficiary is allowed to change the amount (by either increasing or decreasing it).
Joint and Survivor Life Income Annuity
By going with the joint and survivor income annuity life insurance settlement option, you and another individual, such as a spouse or partner, can receive an income stream that is also in the form of an annuity.
Here, the amount of the income payments will be based on the amount of the policy’s death benefit proceeds, as well as the life expectancy of the income recipient who is anticipated to live for a longer period of time. Income will be received until the second recipient passes away.
As with the regular life income option, the portion of the income payment that is considered principal is not taxable. However, the portion that is considered to be gain will be subject to income tax.
Is the Cash Value of Life Insurance Taxable?
Some life insurance policies are purchased for the sole purpose of providing a death benefit. The policies that are typically best for this goal do not include a cash value or savings component. These are referred to term policies. Term insurance is considered to be the most basic form of life insurance protection.
There are also permanent life insurance policy options. With this type of life insurance, there is both a death benefit component and a cash value component. While these policies may cost more in premium (at least initially) than a comparable term life plan – with all other factors being equal – there are some definite advantages to going with a permanent life insurance policy.
One of these is the fact that the cash value inside of the policy is allowed to grow and compound on a tax-deferred basis. This means that, as the cash value grows, the gain will not be subject to taxation, as long as it remains inside the policy.
The tax-deferred nature of the cash value can provide the opportunity for the funds to increase exponentially. This is because interest will be received on the cash that is in the policy, as well as on the funds that would otherwise have been taken out in taxes.
In some cases, an insurance company may also pay out dividends to its life insurance policyholder. This can help to increase the cash value of the policy even more.
In this case, then, are life insurance dividends taxable?
The answer is typically no. This is because life insurance policy dividends are considered to be a return of excess premium. Therefore, they are not considered to be taxable income – and can, in turn, help to increase the policy’s cash value even further.
Policyholders can withdraw the funds from the cash value of a policy for any reason. This could include the payoff of debts, the supplementing of retirement income, or for helping a child or grandchild pay for a college education.
If the cash is withdrawn, though, the amount of the withdrawal – up to the basis in the policy – will not be taxed. In other words, the amount of the money that you paid in as premium will not be taxable to you. However, any interest and/or dividends that are withdrawn will be taxable as ordinary income to you.
Do You Have to Pay Income Tax on Life Insurance?
Even though the beneficiaries of a life insurance policy may not be required to pay income tax on life insurance proceeds, the policy proceeds may or may not be completely tax-free. That is because there is another type of tax that the beneficiary (or beneficiaries) could be responsible for paying. That is an estate tax.
To what extent are life insurance proceeds taxable in this case?
Individuals whose estates are worth over a certain amount may be subject to estate taxes. In 2017, the amount of the estate and gift tax exemption is $5.49 million. This amount has increased from $5.45 million in 2016.
What this means is that a person can leave up to $5,49 million (in 2017) to loved ones and other heirs without having to pay a federal estate or gift tax. For a married couple, this means that $10.98 million can be shielded from federal estate and gift taxation.
When determining the amount of a person’s estate, there are a number of assets that are included in the calculation. These can include your:
- retirement accounts (including 401k and IRA funds)
- money that is held in a bank account
- funds that are in personal investment accounts
- U.S. savings bonds
- personal effects like jewelry and furniture
- personal property such as vehicles and boats
- real estate
- closely held business interests
- and of course, life insurance proceeds.
So, for example, if the death benefit of a life insurance policy that is owned by the insured has a death benefit of $500,000, then this amount will be included in the person’s overall estate value when he or she dies. In this situation, it could also be subject to estate taxes. There is, however, a way to remove life insurance proceeds from a person’s estate. Doing so means that the death benefit funds can still be utilized, but not be taxed by Uncle Sam.
Is a Life Insurance Policy Part of the Estate?
Many insurance and financial professionals say that life insurance creates an “instant estate.” It does so because the funds that are received from life insurance can provide a financial cushion – in some cases, a fairly sizeable one – so that beneficiaries can carry on financially.
Depending on how a life insurance policy is owned, it may or may not be a part of the insured’s estate. For example, if the policy is owned outright by the insured, then the proceeds will generally be included in the estate, and in turn, will be taxable.
If, however, ownership of the policy is removed from the insured’s estate, the proceeds may be free of estate taxation. One of the most common ways to remove assets from an estate is through the use of an Irrevocable Life Insurance Trust, or ILIT.
This type of trust can not only help with protecting the value of life insurance policy proceeds after death, it may also be able to protect life insurance policies from creditors during the insured’s lifetime.
So, when exactly is life insurance taxable?
The short answer is that if the value of an estate is in the range that it will be subject to federal estate taxes (in 2017, this is $5.49 million), then the proceeds of a policy could be liable for this type of taxation.
Are Life Insurance Premiums Tax Deductible?
In addition to the question of whether or not life insurance proceeds are taxable is the question of whether the premium for life insurance is tax deductible. In this case, the premiums that are paid on a personal life insurance policy are considered to be a personal expense. Therefore, they are not tax deductible. So an individual would consider his life insurance premiums to be tax deductible.
However, when life insurance is purchased in conjunction with a business, there could be deductions allowed. For instance, life insurance premiums can be tax deductible as a business-related expense. Generally, an employer that offers group term life insurance coverage to the company’s employees can deduct the premium amount for the first $50,000 of coverage that the company pays. Likewise, the amount up to this limit will also not be counted as income to the covered employees.
Premiums that are paid by a business that is for life insurance coverage that is offered in conjunction with a non-qualified benefit plan, such as executive bonuses or deferred compensation, can also typically be deducted by the company. Here, however, the amount of the life insurance policy premiums can be considered compensation for the key executives under the rules of such plans. (It is important to note that in some instances, the tax deduction may not be taken by the company until the covered employee constructively receives the benefit).
There are also other types of retirement plans that may be funded with life insurance premiums that are tax deductible to a business. These may include:
- defined benefit plans
- 412(i) plans that are qualified
(A 412i plan is a plan that offers fully guaranteed retirement benefits and that is funded either with guaranteed annuities or with a combination of annuities and life insurance. These plans are typically used with larger businesses, due to a large amount of premiums that must be paid each year).
The Difference Between the Death Benefit and the Cash Value of Life Insurance
Because there are two primary parts of a permanent life insurance policy, it can be somewhat confusing to keep track of how the taxes come into play in each component. Overall, though, the key difference is that the death benefit proceeds are free of income taxation. However, if these proceeds are included in the insured’s estate value, then these dollars could be subject to estate taxes.
When it comes to the funds that are in the cash value portion of a permanent policy, as long as the money remains in the policy, the cash value is allowed to grow on a tax-deferred basis.
There are two ways that the cash value of a life insurance policy can be accessed by the policyholder. If he or she withdraws these funds, the money that is attributable to gains (such as interest) will be taxed as ordinary income to the policy owner. If, however, the money from the policy’s cash value is taken out as a loan, these dollars will be tax-free.
It is important to note here, though, that even though a life insurance policy loan is not required to be repaid, if the insured dies while there is still a balance outstanding, the amount of this balance – plus interest – will be subtracted from the total amount of death benefit proceeds that are paid out to the beneficiary.
The Bottom Line on Is Life Insurance Taxable
While life insurance can provide you with a number of key tax advantages, it is important that you have a good understanding of how the tax consequences can come into play when receiving the death benefit proceeds and/or accessing the money that is in the cash-value component of the policy. Knowing how – and how much – you or a loved one may be taxed can help you to plan in other areas of your overall financial life as well.
It can also be reassuring to know that the life insurance policy that you or a loved one is covered by has come from a quality and reputable life insurance carrier. In order to narrow down which policy and the insurance company may be the best for you, it is advantageous to work with an independent life insurance brokerage or agency. These entities will have access to numerous carriers, rather than with an insurance professional who can only offer the coverage products from one single insurer.
With that in mind, working with an independent life insurance broker will allow you to determine which insurance company, policy, and premium will be the best for your specific needs.
Contact us when you’re ready to move forward. We offer life insurance protection from more than 40 different top-level carriers in the market. We can help you to choose the type and the amount of coverage that is needed for both your short- and your long-term financial goals. If we have answered your question, is life insurance taxable can you please share.