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You may know that life insurance is a tool that provides your loved ones with a sum of money upon your death, but do you know if that sum of money will be considered taxable to the Internal Revenue Service? The premise of life insurance is rather easy to understand. It’s the complexities that lie just beyond sight that consumers need to take the time to worry about. One of those complexities is related directly to taxes, and since you’re buying the insurance to provide your family with financial support, you should be familiar with how earnings and proceeds are viewed by the government. Start comparing life insurance now by our FREE tool above!
When you pose a straightforward question asking whether or not life insurance is taxable, there’s not just a single answer that’ll be 100% correct all the time. It all depends on whether you’re worried about taxation throughout the life of the policy or when the proceeds are disbursed. It also depends on the type of policy you’re carrying, whether it’s group life or individual life, and how you have your policy setup at the time a claim is filed.
Since the answer can be extremely overwhelming, it’s easier to consider each and every scenario individually. Here’s your guide to life insurance and taxation so that you have a powerful tool to reference as you’re buying coverage and comparing premiums:
Are life insurance proceeds taxable to the named beneficiary?
If the main reason you’re buying insurance is to provide your family with a large sum of money to pay for living expenses, mortgages, education costs and debt payoff, then it’s important to understand whether or not your life insurance policy proceeds are taxable. You might think this very specific question has one answer, but that’s not the case.
Amazingly enough, there are situations where life proceeds can be taxed, but in a majority of situations these proceeds go entirely to the named beneficiary. If you purchase either term life or permanent insurance, it’s very important that you know that the way the policy is designated is what’s ultimately going to determine whether your heirs get the entire face value or a reduced amount subjected to taxation.
How are proceeds handled after the death of an insured person?
When a death claim is filed, the insurance company’s first concern is investigating it. Once they’ve verified that the cause of death is covered and there are no red flags, they’ll begin to process the claim and reach out to the listed beneficiaries so that they know who to make the proceeds payable to.
How you structure your policy and the specific instructions you give the insurer is what’s going to have an impact on taxation.
Many times, proceeds that are paid will receive favorable treatment, but that’s only when a list of IRS requirements are met. When proceeds are consider part of a person’s gross income, they are typically up for grabs for taxation as well. Here are some scenarios and how proceeds are viewed by the Federal government.
Named Beneficiaries with a Lump Sum Payout
One of the most common ways to structure a term life policy is to name one or more beneficiaries and to designate a percentage of the payout that goes to each. In the end, the lump sum will be paid out to the named payees in a single disbursement. If this is how you plan on setting up your policy, you’ll be happy to hear that proceeds because of the insured person’s death that are paid directly to a named beneficiary are not included as taxable income.
In simple terms, the entire amount that you designate to the individual(s) will be given to them. The only time this can become complex is when the deceased is a co-debtor with the beneficiary. In this case, creditors may have the right to make a claim on proceeds before there’s a payout. Still, these payouts are not taxed.
Named Beneficiaries With an Annuity or Installment Payout
If you decide against a lump sum payout and for an annuity payout, there are new issues to familiarize yourself with. A life annuity payout may be a great idea when you want your beneficiaries to have a regular income coming in to cover expenses, but the could lead to some taxation.
Installment payouts are taxable only when interest is earned. Still, the proceeds in the installment can’t be taxed, but whatever interest the company is paying out for choosing this type of structure do need to be reported and can be taxed. There could be exceptions in your state if the proceeds are being paid out for the death of a spouse that are worth learning about.
Named Beneficiaries When on a Life Policy Earning Interest
Permanent insurance has its benefits. Not only do you get to enjoy tax-free growth and rising cash values, you’ll also have peace of mind in knowing the face value will follow you for life regardless of your health. Unfortunately, the benefits can come at a cost if you’re not planning in advance.
If you’re leaning towards buying a permanent insurance policy, there are very different taxation issues that can arise. Since permanent policies are the only types of life plans that earn interest, it’s possible for a beneficiary to be required to file what they believe is a portion of their proceeds are taxable income.
In actuality, it’s only the interest that’s been accrued on the policy that must be filed and then taxed.
This specifically happens when the life insurance payout is broken down into the death benefit and interest sitting in the policy’s cash account. The face value of coverage that the insured is paying for is not taxable, but if the funds are earning interest you may receive a 1099 as a beneficiary. So, if there is a payout of $103,450 and only $100,000 of that was the death benefit, the $3,450 interest payment is subject to taxation.
Some owners may elect for the beneficiary to receive only principal to prevent taxation and others will not. Others may have the interest that accrues in the policy purchase more insurance so that it offers the beneficiary a better payout instead of raising their tax bracket.
Life Proceed Taxation With No Listed Beneficiary
One of the biggest mistakes that anyone can make when building a policy is to leave the beneficiary portion of the application blank or to fill in “estate”. If there’s no beneficiary it’s treated the same as naming the estate as the beneficiary.
When proceeds go to the estate, they go through probate and will raise the value of the estate. This means that the estate tax will be extremely higher because the proceeds are seen as income before it’s handed over to an heir or an executor. This means that much more of the money is going to the government than to your family.
To prevent this from happening, you’ll need to estate plan and transfer the ownership of the proceeds to a person or an eligible entity. Either naming your beneficiaries or listing an irrevocable trust can keep your benefits in your family’s hands as intended. You will then need to name a trustee and list ways that you want the money to be handled. Trusts not only protect the proceeds from being eaten up by taxation, they also help ensure the trustee follows your wishes when you’re gone.
Is life insurance taxable to the named insured?
Taxation issues are really only an issue when you purchase a policy that earns cash values and that you intend on using as a living benefit. If you own a universal life or whole life policy, it’s important that you think about how using the policy as a savings account can increase your tax obligations.
One way that life insurance can be taxable to the owner while they’re living is if you surrender the policy for the proceeds.
Anything above the amount you paid into the policy in the Cash Surrender Value will be seen as interest earned. The excess earnings are taxable income and you will receive a 1099-R to show the taxable part that will need to be filed the next tax year on lines 16a and 16b of your 1040 form.
Another example of tax implications associated life insurance is when you withdraw from the policy and part of your withdrawal is interest earned. To avoid this, you can simply take out a loan and may a repayment plan so that you’re not penalized.
So much taxation and so little time. This is why it’s important that you know what you’re buying before you buy it. Once you have a plan in place, you can start to look for the most affordable policy that will set your plan into motion. Remember, estate planning is important but it takes just minutes to compare premiums when using an online comparison shopping tool. Start comparing life insurance rates now by entering your zip code in our FREE tool below!