Is life insurance taxed? It would be great if this one question could be answered with one response. Understanding the tax rules on life insurance can’t be answered with 1 simple answer unfortunately.
Top 10 Life Insurance Tax Tips
Here are the 10 most common life insurance tax situations and answers to the questions that many shoppers have.
Life insurance beneficiaries don’t pay income tax on received death benefits (usually)
The beneficiary of your life insurance policy (whoever receives the death benefit) typically will not pay state or federal income tax on the proceeds of the benefit. For example, if you own a $1 million dollar life insurance policy, the beneficiary of the policy will typically not pay income tax on the $1,000,000 death benefit.
Here is a situation where it might be taxed. If the life insurance death benefit is paid out in installments vs a lump sum payment. If there is interest on each paid installment, the interest portion is typically taxed to your beneficiary. The principal portion is tax free, but the interest portion is the part that is taxable at ordinary income rates.
Life insurance contracts have to meet IRS requirements
To be considered a life insurance contract for federal income tax purposes and be qualified for favorable tax treatment – it has to meet the IRS’s statutory definition as well as the state law requirement of what is a life insurance policy (as well as what is not a policy). The IRS sets this up to make sure that your life insurance policy is not actually an investment vehicle. Life insurance companies have to comply with the IRS’s rules and have to enforce these rules.
Life insurance premiums on personal policies are not tax deductible
The premiums you pay on a personal life insurance policy is looked at as a personal expense. These are not tax deductible. The IRS states that the premiums paid for life insurance by the insured is not tax deductible. It does not matter if the life insurance premiums are paid by the insured or someone else. It should be noted that life insurance premiums are not tax deductible, they could be if they’re the payment of charitable contributions or payment of alimony.
Life insurance beneficiaries can be required to pay estate taxes attributed to death proceeds
There are two situations where a life insurance beneficiary may be required to pay estate tax.
- The first is when the insured has stated in their will that the beneficiary will pay the share of death taxes that are attributed to the proceeds.
- If the state of the insured’s domicile has a written statute that allocates the burden of death taxes among the non-probate and probate life insurance beneficiaries without the presence of explanation from the insured about who is responsible for the death taxes.
Cash value for permanent life insurance policies accumulates tax deferred
Term life insurance does not build cash value. However, some permanent life insurance polices like Whole life insurance have savings component that builds cash value. Over time, the cash value grows and it’s possible that at some point your policy may have more cash value than the total amount of premiums paid into the policy. You are typically permitted to defer the income taxes on the policy’s gains. This is true just as long as you don’t withdraw, surrender or sell your life insurance policy. If you do one of those , you will be taxed as ordinary income on the difference of what your paid and what you get back.
No taxes on loans taken from your policy
The amount of the loan taken against the cash value grown in your life insurance policy in not taxed. The exception to this is with a MEC. When you take a loan against your life insurance policy, the cash value and the death benefit of your policy will reduce.
Exchange 1 life insurance policy for another without paying taxes
You may be able to exchange your life insurance policy for another type of policy and not be subjected to a tax liability. The way the tax code is structured allows you to exchange your life insurance policy for another policy without incurring a tax liability situation. This exchanging of life insurance policies is called a Section 1035 exchange. There are rules that you need to follow that the IRS have provided.
Cash surrender value can be taxable
Are you looking to surrender the cash value of your life insurance policy? If there are any gains on your policy they will be subjected to state (possibly) and federal income tax.
You are not taxed on paid dividends (usually)
There are permanent life insurance policies that pay out dividends. These policies are known as participating policies will pay you back a dividend. Dividends are the amount of your life insurance premium that’s paid to you when life insurance companies have lower expenses and mortality claims than expected. It’s paid from the carrier’s annual surplus earnings. These dividends are considered a return of your premium. There is no tax due on the dividends just as long as you didn’t get back more than what you paid in.
Life insurance as part of an estate will be taxed
When a life insurance policy is part of one’s estate, it will be taxed when the estate is valued over and above the current federal estate tax exemption.
Is life insurance taxed?
The bottom line is that in most situations, life insurance is not taxed. At Life Insurance Blog, we work with dozens of the best life insurance companies to find the ones that meets the needs of our clients.
If you need help, more information, advice or have questions about your life insurance needs, then please let us know. We would be happy to help you out.