You may be asking yourself, “What exactly is a life insurance policy, and do I need one?” Good question. We’ll give you the short version. A life insurance policy is essentially an agreement between you and a life insurance company that will pay out an agreed-upon amount of money to your beneficiaries upon your death via a death benefit in exchange for payment(s) made while you are alive. A beneficiary is a person or people you assign to receive your death benefit after you’ve passed. It can take up to two months from the time they file a claim for your beneficiaries to have that death benefit paid out to them. Usually, these death benefits aren't taxed, but there are some specific instances where they are.
Most of the time the death benefits your beneficiary receives from your life insurance policy are not taxed as income, but there are some instances that you should be aware of where that is not the case. One main case is if you elect to have your death benefit paid out in installments. Another way that your death benefit could be taxed is through estate and inheritance taxes.
By default, death benefits are typically dispensed to your beneficiary in a lump sum. That means your beneficiary gets the full amount of your death benefit all at once via bank transfer or check. But there are a couple of other ways to dispense your death benefit.
The first way is through an annuity. With the annuity option, the life insurance company transfers your death benefit into an annuity, which allows your beneficiary a set amount of money over a predetermined period of time or, in some cases, for life. Any interest accrued would be taxable to the beneficiary.
You could also elect to have your death benefits paid out in installments. This process is also called a specific income option, which means your beneficiary receives their benefit in payments until the death benefit is fully paid out. However, with this type of plan, these payments would be subject to income tax to your beneficiary.
As long as the total value of your estate is lower than state (ranges from $1 million to $7 million in 17 states plus Washington D.C.) and federal exemptions (less than $15 million per individual), the estate won’t have to pay taxes on the payout. But if your estate is valued higher than the exemption rate, any amount over could be taxed.
There are a handful of instances where cash value becomes taxable. The first is when you make withdrawals from your policy that exceed your cost basis. The difference becomes taxable as income when you withdraw more than you’ve put in.
When you surrender your policy, you won’t be taxed on the entire amount of your plan. You'll be taxed on the cash you received from the surrender, less the total premium payments you made on the policy. If you choose to sell your life insurance policy through a life settlement, the IRS will view this as income that can be taxed.
Let’s get more in-depth with how you pay taxes on the sale of a life insurance policy. As we said before, the IRS will consider the money you receive from the sale of a life policy as income if you haven’t proven that you are terminally ill. But the amount of taxes you would owe depends on how much you’ve already paid in premiums. The more premiums you’ve paid over the life of your policy, the less taxable income would be generated from the sale.
Surrendering a life insurance policy is essentially just terminating your coverage. At that point the insurance company will pay out your policy’s cash value minus any remaining surrender charges and expenses that apply. What ends up being taxable is any the portion of your cash value that exceeds the policy basis. For example, if your policy is worth $25,000 upon surrender with a policy basis of $7,000, the IRS will consider the additional $18,000 as income and tax it.
As mentioned above, any withdrawal of cash value above basis in the policy will generally be considered taxable income. If you have an option to take a policy loan, however, these amounts are generally not taxable as long as the policy remains in force and the debt does not exceed policy basis. It's important to remember that withdrawals and unpaid loans will reduce your policy death benefit.
The life insurance tax types that we’re about to go over provide a deeper look into the topic from above when we discussed situations in which your life insurance policy becomes taxable.
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