Life insurance is a great way to leave a safety net to your loved ones.
But will that money belong solely to them? Is life insurance taxable?
Coping with the death of a loved one is never easy. But in addition to the emotional turmoil you may be feeling, there are often financial problems as well. The surviving family may need help paying for funeral costs, offsetting lost income, and adapting to the inevitable change in their lifestyle.
Life insurance helps alleviate much of this anxiety, but it can bring up an interesting, yet valid, question: Is life insurance taxable?
In most cases, life insurance isn’t taxable as it’s not counted as gross income. However, there are cases where it is. This usually comes down to how you classify your beneficiaries and how the life insurance payout is made.
Let’s explore some scenarios where life insurance would, and would not, be taxable.
Who Should Have Life Insurance?
Life insurance is an agreement between an insurer and the policyholder, in which the insurer agrees to pay an amount of money to a selected beneficiary after the insured person’s death.
Other circumstances, such as terminal or severe illness, may also trigger payment based on the contract. The policyholder normally pays a premium, either regularly or in one lump payment.
Our expert opinion is that everyone should have a life insurance policy.
Life insurance is the best way to make sure your surviving dependents have a safety net to prepare for your unexpected passing. Even if you don’t have dependents, life insurance benefits can help pay for any outstanding debt (including funeral costs).
Who Can Be Your Beneficiary?
Every life insurance policy has an assigned beneficiary. The beneficiary is the person or organization who will receive the benefits upon your demise.
In most cases, you will pick a primary beneficiary as well as a contingent beneficiary/ies who will receive the death benefits if the primary beneficiary isn’t available.
Keep in mind that while you can choose who your beneficiaries are, children under 18 cannot be named as beneficiaries on a life insurance policy.
When Is Life Insurance Taxable?
Life insurance death proceeds are not taxable in terms of income tax as long as they are paid out totally as a lump-sum, one-time payment. However, if the policyholder chooses to spread the payout over time, the beneficiary must pay taxes on the interest earned during that time.
If you want to maximize the tax-free possibilities of a death benefit, you must understand how your insurance should be structured.
Taxable to the Policyholder
Policyholders can access cash values accrued under whole or permanent life insurance policies.
The loan is not generally taxed if the policyholder agrees to borrow against the cash values of the insurance. If the loan is not returned before the policyholder’s death, the death benefit will be reduced by the loan amount.
If a policyholder chooses to surrender their policy instead of obtaining a loan in order to receive all cash values and lapse the policy, the cash value proceeds may be taxed.
Taxable to the Estate
What happens if the policyholder does not specify an individual or trust as the beneficiary of their insurance policy? In that case, the death benefit money will be given to the policyholder’s estate.
When this occurs, the profits of the life insurance policy are included in the deceased individual’s gross estate, which may be liable to federal estate taxes.
If the insured’s spouse is specified as the beneficiary of the life insurance policy, the death benefit funds might also become part of the insured’s estate. The death benefit payments are paid out and form part of your spouse’s liquid assets when your spouse gets them. They can then be invested or preserved.
When that spouse dies, and their assets are transferred to their estate, the profits of your death benefit will be included in their total estate and may be liable to federal estate taxes. The simplest method to avoid this is to give your death benefit to a trustee.
Taxable to Beneficiaries
If the beneficiary you choose on your life insurance policy is also the policy owner, that person has an incident of ownership interest in your cash values. As a result, when benefits are provided, they may become taxable income to that individual.
You can avoid this outcome by retaining ownership of your insurance or having it in a trust.
When your death benefit money is distributed, your beneficiaries will be asked to select a payment method for the insurer to use. They can have the insurer pay payments in installments or as a lump sum, which is a one-time payment that covers the entire death benefit.
When the death benefit is paid in installments, the death benefit continues to generate interest. Any percentage of an installment received via this continuing interest accrual may be taxed.
When a lump sum payment is made, if your beneficiary invests the lump amount and generates a profit, they may be subject to a short or long-term capital gains tax when they sell the asset. They may also be taxed on dividends and interest earned by the investment.
What Can Your Life Insurance Go Toward?
A life insurance payment will give much-needed financial help if you lose a spouse or partner. When it comes to where your life insurance benefits can go, you have numerous alternatives.
Many people choose to get life insurance as a way of leaving an inheritance to their loved ones. However, this is not the same as leaving someone money in your will.
Your beneficiary will only receive the death benefit, not personal belongings, funds from your savings account, or real estate. Life insurance payouts also don’t have to go through the probate process.
In other words, regardless of what happens to your estate, your beneficiaries get compensated.
Paying Off Debt
Whether you have credit card debt, personal loans, or high-interest student loans, your death will not automatically discharge your debt. A life insurance payout can help relieve the burden on your family members.
Like most parents, you’ve probably spent some time thinking about your kids’ college fund, and a life insurance benefit is an excellent way to help pay for that.
But life insurance can also help surviving spouses pay for the education to reenter the workforce, change careers, or increase their earning potential.
When people think about giving to charities, life insurance is sometimes ignored as a gift choice, but it may be a valuable method to provide charity money for future activities. So, giving a life insurance policy as a present would be something to think about.
Paying Federal or State Estate Taxes
Not only is a one-time life insurance payout not taxable, you can actually use the money to offset other tax payments!
If you anticipate having to pay an estate tax to pass an inheritance to your children, a life insurance payout can be used to help cover the costs.
Let Harry Levine Insurance Find the Right Life Insurance Policy for You
Any wise financial and long-term planning should start with purchasing life insurance as soon as possible. It is often one of the more affordable insurance policies on the market and allows us to ensure our loved ones are still taken care of after we’re gone.
Contact Harry Levine Insurance to discuss what plan would be best for you and your family and get a free life insurance quote.