Life insurance policies are a way to financially protect your loved ones after you pass away.
But will your beneficiaries owe taxes on the life insurance payout?
Usually, no, you dont have to pay taxes on life insurance payouts.
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But like most general rules, there are a few exceptions.
Is Life Insurance Taxable?
In most cases, life insurance policy proceeds are not taxable.
When your beneficiaries receive a death benefit the payout from the insurance company its generally considered a non-taxable event.
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Thats because the IRS doesnt view life insurance payouts astaxable income.
However, some people choose to have their life insurance proceeds spread out over time, creating anannuity.
You dont have to pay taxes on the principal amount though.
Most people dont have to worry about estate taxes.
Your estate must be worth a substantial amount $12.93 million in 2023 to trigger federal estate tax.
And the entire estate isnt subject to taxation, just the portion that exceeds $12.93 million.
Seventeen states also levy their own estate taxes, sometimes with lower limits.
In Oregon, for example, estate tax kicks in after $1 million.
You wont personally have to pay estate taxes.
you’re free to also name contingent and secondary beneficiaries.
Lets break it down a bit.
The insured is the person whose life is covered by the policy.
The policy owner is the one who buys the policy.
And the beneficiary is the person who gets the life insurance proceeds if the insured person passes away.
That means you might be on the hook for gift tax because youre considered the donor.
To avoid any tax implications, its best to keep it simple.
Stick with two people on the policy.
That way, you steer clear of the gift tax mess.
Heres how it works.
The amount received from a life settlement is tax-free up to the premiums youve already paid into the policy.
This is called your cost basis.
Lets say youve paid $10,000 in premiums since you bought your policy.
If you sell it for $20,000, the first $10,000 of that sale isnt taxable.
After that, the amount up to your policys cash surrender value is taxed at your ordinary income rate.
The rest is taxed at thecapital gains tax rate.
The settlement wont be taxed at all if proceeds are less than the premiums youve paid into the policy.
Generally, viatical settlements are spared from taxation.
If you receiveIRS Form 1099-LTCafter selling your policy, the proceeds are usually tax-free.
Taxation of life settlements can get really complicated.
Surrendering the Policy
Surrendering a life insurance policy is basically the same as canceling it.
Thats because this excess amount is considered a taxable gain.
For example, youve paid $25,000 in premiums on your $1 million whole life policy.
Over the last 10 years, the cash value grew $5,000.
This can happen if the interest on the loan becomes greater than the policys cash value.
When this happens, the insurance company can cancel the policy, leaving you with a tax bill.
Frequently Asked Questions (FAQ)
No, life insurance premiums arent taxable.
Thats why life insurance premiums arent tax deductible on your yearly tax return either.
However, taxes only apply when the employer pays for more than $50,000 in life insurance coverage.
Your tax obligation hinges on the cost of the group life coverage beyond that $50,000 threshold.
Your employer-provided life insurance coverage amount is $100,000.
So, if your monthly premium is $100, then $50 of that payment would be taxable.
Your employer will include the cost of the excess coverage in your reported wages.
These dividends are considered a refund or credit rather than income.
This can happen if the dividends are held in an interest-bearing account.
Rachel Christian is a Certified Educator in Personal Finance and a senior writer for The Penny Hoarder.
She focuses on retirement, life insurance, investing and taxes.
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