Guide to Life Insurance and Taxation
Life insurance is a fantastic way of establishing a financial safety net for your dependents. This insurance policy can help your beneficiaries pay for a mortgage, college fees, or other expenses after your death. Although most lumps of money, such as lottery winnings, are subject to tax, life insurance proceeds are typically not.
You may be wondering, is life insurance taxable? If you die while your policy is still active, the insurer will pay your beneficiaries a tax-free lump sum. But if you hoped to receive insurance payout installments, have a large estate, or opt for cash value life insurance, you may encounter some tax implications.
You may also face capital or income tax if you choose to get rid of your policy by surrendering to your insurer or via a life insurance settlement. Keep reading for more information on the tax implications of life insurance.
Is a Life Insurance Payout Taxable?
Typically, lump-sum life insurance payouts paid out to individual beneficiaries do not involve federal income tax. This means you should not report these payouts to the IRS or include them in your gross income.
For example, suppose you are a beneficiary of a life insurance policy from your spouse, parent, or another person, and you receive a payout after the person dies. In that case, you will not pay any tax on that payout. Now suppose you are the person covered by the policy and are receiving accelerated death benefits because of a terminal illness. In that case, you will also not pay any tax on the payouts.
When Is a Payout Taxable?
You may have to pay tax on a portion of the life insurance proceeds under certain circumstances. The following may involve taxes:
- The transfer of the policy is partially taxable
- The interest is taxable
- The cash surrendered is partially taxable
Will I Pay Tax for Cash Value in Life Insurance Policies?
One of the chief advantages of cash value life insurance is that earnings on the cash value do not attract a current tax liability. Typically, earnings on the cash value will increase on a tax-deferred basis until:
- You transfer the policy for value by either signing or selling it
- You cash in the policy
- The policy no longer meets the IRS definition of a life insurance contract
Ordinarily, you will not incur any tax liability until one of the above events occurs. If you receive proceeds from your life insurance contract, the benefits will not be part of your gross income. However, any interest you receive will attract tax.
If you decide to withdraw the policy, you will not incur any tax for the amount paid into the policy. Remember, you’ll need to pay tax if a policy is modified via an endowment contract. Taking a policy loan can attract severe tax consequences, especially if the policy ends before the insured’s death.
Is Group Term Life Insurance Taxable?
According to IRC section 79, you will get tax exclusion for the first $50,000 whether the group term life insurance policy is carried by an employer directly or indirectly. This means that there are no tax consequences if the coverage does not exceed $50,000. Any costs of the policy over $50,000 should be part of your income. These costs are also subject to Medicare and Social Security taxes. Your employer can calculate the taxable cost of group term life insurance over $50,000 based on IRS guidelines.
Coverage Offered by More Than One Insurer
If the coverage comes from more than one insurer, it will be treated separately to establish whether the employer carries it directly or indirectly. But if you have more than one policy from the same insurer, combined tests will apply to determine whether the employer carries it directly or indirectly.
Are Life Insurance Dividends Taxable?
Permanent life insurance from an insurance company will attract periodic dividends if it’s a mutual insurance company. This is because it treats the policyholders as the owners of the company. If the amount you get in dividends is less than what you paid in premiums, it will not attract any tax.
With permanent insurance policies, a portion of the premium becomes part of the policy’s cash value every time you pay your premiums. The cash value refers to the amount of money you receive if you decide to surrender the policy to the insurer. The cash value growth is tax-deferred and will be subject to the interest rate set in the policy terms.
You can apply for a tax-free loan from the insurer and use the cash value as collateral, provided the loan is not more than the cash value. Unfortunately, if the loan amount is more than the cash value, you may pay taxes on the loan.
Consequences of Cashing in Your Life Insurance Policy
What are the tax consequences of cashing in a life insurance policy? Typically, your beneficiaries will not pay any income tax when receiving death benefits from your life insurance policy. However, if you decide to cash in the policy, you may pay some tax.
If you have a cash value policy and want to withdraw more than the money it has gained, this will be taxed as part of your ordinary income. The best option is to check with your insurer before you decide to cash in the policy. For example, some life insurance policies are taxable in the first 15 years.
1035 Exchange Inherited Annuity
According to IRC section 1035, an original owner of a non-qualified annuity can exchange the product with another without the exchange being considered a sale. In this case, no tax liability will incur. However, the annuity exchange will only be tax-free if the new annuity is payable to the same person who was to receive the annual payouts in the first case.
Gift Tax Life Insurance Premiums
If your insurer offers group term life insurance coverage that exceeds $50,000, you will have to include the premiums for this policy and all contributions you have made towards the plan as part of your income. The good news is that if the value of the life insurance death benefit is less than $50,000, you will not include the premiums in your income. In this case, you’ll enjoy gift tax.
How to Protect Your Life Insurance Proceeds
Life insurance is a way of safeguarding the financial stability of your loved ones in case you die. The best way to avoid paying tax on life insurance benefits is to name your loved ones as beneficiaries. If you name your estate as a beneficiary, the payout may incur some tax liability.
The best option is to consult a tax professional or your financial advisor to learn the best ways of minimizing tax on your life insurance policy.
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