While life insurance payouts are typically tax-free, certain circumstances do apply. For instance, interest received from life insurance proceeds is subject to taxation. Furthermore, when the policy’s beneficiary is a large estate, the policy’s proceeds may be subject to estate taxes.
To avoid surprises, be aware of the following information regarding taxes and life insurance.
Are Insurance Benefits Taxable?
One of the best aspects of life insurance is that it is usually not taxable. Generally, your beneficiaries are not required to pay income taxes on life insurance payouts. However, any death benefit that exceeds your policy basis – the total sum of your premium payments minus dividends and interest earned – may be taxed.
In general, your insurance policy may be taxed in the following circumstances:
When is it Taxable?
The beneficiary is paid in installments by the insurer.
Suppose the beneficiary receives death benefits in installments rather than a single lump-sum payment. In that case, they must pay any interest accrued on the balance.
The payout is included in your estate.
If your estate is a beneficiary whose total taxable value exceeds $12.06 million (in 2022), your beneficiaries must pay an estate tax.
The policyholder withdraws funds from the cash value without repaying them.
Anything that exceeds the policy basis is taxable, which includes insurance premiums and investment gains. The difference between your policy’s cash value and the cost value or amount you paid in premiums is taxable.
The policyholder borrows against the policy.
You will not be taxed if the policy does not lapse.
The policyholder cashes in the policy.
Interest, dividends, and capital gains are all taxable, and additional taxes may apply if outstanding balances exist.
A life insurance settlement company purchases the policyholder’s life insurance policy.
Interest, dividends, and capital gains are all taxable, and there is an additional capital gains tax if the proceeds exceed the cash value.
Types of Permanent Life Insurance
Permanent life insurance is a catch-all term for policies that never expire. Most permanent life insurance policies include death benefits and cash value.
Type of Policy
Index Universal Life Insurance
Like Universal, Indexed is adaptable and lets you alter your premium payments. The increase in cash value is linked to the performance of a stock index. The death benefit is tax-free.
The difference is subject to taxation if the amount withdrawn is more than the policy’s basis.
Variable life insurance
The cash value of your life insurance policy grows based on the investments offered by your life insurance company. There is a risk that the investments will underperform and reduce the value of your death benefit.
The death benefit is tax-free.
Suppose you withdraw money from your policy and do not pay it back in full before death. In that case, your beneficiaries may be subject to federal income tax.
Whole life insurance
You make fixed premium payments for the duration of the policy. While your policy is active, you will receive a guaranteed death benefit and fixed cash value growth.
The death benefit is tax-free.
Any interest you earn, however, is taxable and must be reported. Withdrawals that exceed the policy basis are taxable.
Universal life insurance
Premium flexibility and death benefit. The cash value is not fixed and can fluctuate. Interest rate fluctuations in the market drive its expansion.
There is no tax on the death benefit.
However, you must declare and pay taxes on any interest you earn. Any withdrawals made more than the policy basis will be subject to taxation.
Variable universal life insurance
Death benefits are optional, and premiums are flexible. The cash value of your investments grows. The death benefit is tax-free.
Withdrawals that exceed the policy basis are taxable.
Is the cash value of a permanent life insurance policy tax deductible?
When your permanent life insurance policy accumulates cash value over time, it is not always tax-free to access that equity. While it is uncommon, it is possible to face significant taxes in certain circumstances.
Obtaining a Loan Against Cash Value
While cash value loans are not taxable, you will have to pay taxes if you do not repay your loan or let your policy lapse. If your insurer cancels your policy, the cash value will be used to repay your loan, and any amount that exceeds the loan amount will be taxed. If you die before the loan is paid off, any outstanding balance will be deducted from what your beneficiaries receive.
Offering the Life Insurance Policy for Sale
When selling your policy, the IRS will look for two types of taxes:
Income tax: Any financial growth above the policy level (e.g., dividends and earned interest)
Capital gains tax: Any financial growth exceeding the policy’s cash value is subject to capital gains tax.
Suppose you want to avoid paying capital gains tax. In that case, you could use section 1035 of the tax code to exchange an older policy for a newer one with more desirable features.
Is it possible to cash out life insurance before death?
In some cases, you may be able to cash out your life insurance policy while still alive. However, it may depend on your policy type and whether or not it is eligible. While alive, you have several options for cashing out your life insurance policy.
You can borrow money from your policy’s accumulated cash value; however, the death benefit will be reduced if you do not repay your loan in full before you die.
My name is Kevin Wirth and I have worked in the financial services industry for many years and I specialize in life insurance and retirement planning for individuals and small business owners, with a specialty in working with Federal Employees. I am also AHIP certified to work with individuals on their Medicare planning. You can contact me by e-mail or phone. I look forward to the opportunity of working with you on these most relevant areas of financial planning.