Do your beneficiaries pay taxes on life insurance?Life insurance can be an important part of a financial plan, but you may find yourself faced with tough questions about how it all works. Remember this: One of the most important questions when it comes to life insurance concerns taxes -is life insurance taxable?
Will your beneficiaries be taxed?
Generally, named beneficiaries do not pay taxes on the proceeds from a life insurance claim according to the IRS. However, there are a few exceptions. One of which would be a death benefit paid out in installments earning interest. The interest above the death benefit amount will be taxable.
Will your estate pay taxes on life insurance?
The answer depends on the size of your estate. Death benefits paid to a spouse, however, are generally not subject to estate tax. For large estates, currently valued $10 million or more, life insurance proceeds may be subject to estate tax.
When is life insurance taxable to the owner?
Profit from surrendering a cash-value policy
Over time, life insurance policies can build cash value. If you ever decide you don't want your life insurance policy anymore, you may be able to terminate the policy in exchange for a cash payment. This is known as surrendering a policy. If you do choose to surrender your life insurance policy and earn a profit from doing so, the profit portion of the cash value you receive is considered taxable income.
Payouts from a large estate
In some cases, a life insurance payout does not go to a named beneficiary and instead goes to the insured individual's estate. If your life insurance payout becomes part of an estate, it may be subject to estate taxes. This only impacts those with a very large estate. If your life insurance payout goes to an estate worth more than $10 million, it may be taxed.
When is life insurance not taxable?
Payouts to beneficiaries
If you have a life insurance policy, it is smart to keep your beneficiaries updated to reflect those you want to receive the funds. If you are a beneficiary on a life insurance policy and receive a payout, you can expect that life insurance payment income tax free. However, any interest received on a payout would be taxable.
Payouts to a spouse
In a large number of cases, life insurance payments go to a spouse. As long as the payout is made directly to the spouse, the life insurance payment is not subject to estate tax or income tax.
Cash value gains
While there are multiple types of life insurance policies, a permanent* life insurance policy such as a whole life policy may grow in cash value over time. Cash value growth within a permanent life insurance policy is not taxed.
When in doubt, seek expert advice
In most cases you don't have to pay taxes on life insurance proceeds, but if you have any doubt, the best course of action is to seek professional advice. In many cases, a qualified tax professional may be familiar with your scenario. This removes ambiguity from your tax preparation and better ensures you don't end up on the wrong side of an audit or penalty.
Stay aware of life insurance tax implications
With life insurance playing an important role in estate planning and financially protecting your family for the future, you don't want your loved ones to get hit by a surprise tax bill down the road. Knowing how life insurance taxes work is key in helping your family keep as much of their life insurance proceeds as possible.
Though most of the time life insurance benefits are not taxed, you should always be aware of how your policy works and how changes in tax law might affect your policy. When in doubt, contact a tax professional to ensure you are on the right track.
*As long as required premium payments are timely made.