Life insurance: It isnāt a fun topic to think about, but itās an important investment that can protect and financially take care of your loved ones after you pass.
The magic of life insurance ā whether itās a term or whole life policy ā is that most of the time, proceeds for beneficiaries arenāt taxable. But there are certain situations where payouts will end up getting split between individuals and Uncle Sam.
In these common situations, proceeds arenāt subject to income tax:
This is the most common way life insurance is used: to provide financial means to beneficiaries after a loved one dies. Although this money might seem like income, it will not be taxed by the Internal Revenue Service (IRS), according to its website.
A permanent life insurance policy can build value over time.
Hereās how it works: a portion of the monthly premium is placed aside for a ācash value,ā and the remaining portions are put toward the actual policy and administrative costs. The company then invests the cash value, meaning it grows over the years. Although itās a growing investment, policyholders are not required to pay a tax on the earnings.
Those who no longer want a life insurance policy can āsurrenderā the policy, or cancel it entirely. Surrendering a policy means the insured can have the decision to take the ācash value,ā or the portion of the policy that is available to the policyholder upon surrendering.
Some life insurance policies pay out dividends to policyholders on a quarterly or annual basis. The dividends can be taken as cash, used to reduce a premium, reinvested to earn more interest or to purchase more insurance. These dividends are generally not taxable by the IRS as long as they donāt exceed what the policyholder paid in premiums.
Jennifer Correa Riera, partner of Fuerst Ittleman David & Joseph brings up a point about life insurance that isnāt commonly discussed: payouts while the insured is terminally or chronically ill. Correa says these proceeds, known as terminal illness riders, are treated as an amount āpaid by reason of the death of the insured,ā and therefore are excluded from gross income.
For most people, life insurance proceeds wonāt be taxable. But for some, life insurance will be subject to taxes if itās included in an estate and is above a certain threshold.
Here are the scenarios when life insurance proceeds are taxable:
There are two options for receiving a life insurance payout: in full, or in installments.
āIf the payout is paid in installments, the interest that accrues on the payouts is taxable. The death-benefit is not taxable, only the interest on installments,ā says Jonathan Holloway, co-founder of NoExam.com, a digital life insurance brokerage.
Installment plans may be beneficial for individuals who need the money spread out over a certain period of time, or arenāt sure if they can resist spending the lump sum all at once.
Only spouses are exempt from getting taxed in life insurance policies. Anyone else, like a parent or sibling, will have to pull the proceeds from an estate. This means the money is subject to taxation, if the estate is large enough.
In 2019, the Federal Estate Tax Exclusion amount is $11.4 million for individuals. If someone were to pass away and have an estate valued above that amount, any amount above the threshold would be taxed at 40 percent.
āThis can happen when a beneficiary is not chosen, or the beneficiary passes away before the policyholder,ā says Phil Murphy, vice president of insurance at Ethos. āThis can be avoided by naming a contingent beneficiary in addition to your primary one.ā
There arenāt any limitations on what beneficiaries can do once theyāve received life insurance proceeds. The funds could be used for anything ā including paying off a mortgage, catching up on monthly bills or preparing for future college plans.
But some folks who receive a big chunk of change after a life insurance payout might find themselves in an emotional state ā and not in the best state of mind to make sound financial decisions with the money.
Thomas D. Currey, owner of TDC Financial Services in Grand Prairie, Texas, warns individuals to be careful with their newly acquired windfall.
āThe one word of caution Iād have is that when anyone comes into a large sum of money, itās easy to spend first and ask questions later,ā Currey says. āSeeking counsel to help you assess what your current needs are and how to make it go as far as possible is always a good idea.ā