You’ve probably heard the famous Benjamin Franklin quote, that nothing in life is certain except death and taxes. While both of those (unpleasant) facts hold true, do they necessarily need to co-exist?
In other words, are the life insurance proceeds that your loved ones receive after your death subject to government taxes?
Let’s get straight to the point: No, your life insurance policy’s death benefit is not subject to taxes. While that money can be used in ways that trigger a taxable event, the payout itself is not taxable.
One of the biggest benefits of life insurance coverage is that any payout your loved ones get following your death is provided to them tax-free. Whether your family gets $10,000 or $10 million from your policy, the death benefit they receive will not go toward their taxable income that year.
The proceeds from life insurance coverage do not need to be counted as gross income and your loved ones don’t even need to report the payment when they file their taxes.
Of course, nothing involving taxes could be that simple. So before you run off, there are a few important caveats to keep in mind.
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Depending on how your loved ones use the money from a life insurance death benefit, there can indeed be taxes involved. They just won’t be triggered from the initial payout.
For instance, if your beneficiaries take the money and invest it, or place it in an interest-bearing savings account, they will be responsible for paying taxes on any growth that comes from that initial investment.
If you designate that the funds are to be placed into a trust for your loved ones, the principal investment itself is not considered taxable. However, any interest growth from that point on is taxable income, from an IRS standpoint. Either the trust itself or the beneficiaries will be responsible for paying capital gains taxes on the growth (but again, not on the principal amount).
Generally, life insurance proceeds are paid out to your loved ones in a lump sum. In some cases, though, you or your beneficiaries can choose an annuity (also known as a life income payout), which will instead spread payments out over a determined period of time. Beneficiaries can even request life-long annuity payments, with the payout based on their age and death benefit amount.
While annuity payments of the death benefit itself are still not subject to taxes, the remaining balance is held in an interest-bearing account. Over time, this account will grow and any interest earned is taxable.
If your life insurance policy builds a cash value over time — as is the case with many whole and universal life policies — you, as the primary insured, can generally borrow from this balance as needed.
However, if you take out a loan from your policy’s cash value, some of it may be subject to taxes. There are no taxes imposed on the borrowed funds up to the total amount of premiums you’ve paid into the policy at that point. However, if your policy’s cash value has grown due to interest or dividends, and you withdraw more than you’ve paid into the policy, the growth will be considered taxable.
Additionally, if you fail to repay a policy loan, interest on your loan will accrue. Eventually, the loan and interest balance could outgrow the policy’s remaining benefit, causing it to lapse. The termination would trigger a taxable event, which you would owe even though you don’t receive any remaining surrender value from the policy.
Another benefit to the cash value of permanent life insurance policies is that if you decide to cancel your coverage down the line, you’ll get at least a portion of that money back thanks to the policy’s accumulated cash value.
The amount you receive will usually be subject to a surrender fee or penalty. Beyond that, you can cash out your policy for its surrender value, which may be greater than what you’ve paid in premiums to date. In this case, you will usually be responsible for paying taxes on the surrender amount beyond your total premiums paid, according to your tax bracket.
Buying life insurance coverage is an excellent way to provide your loved ones with a financial safety net in case something were to happen to you. While there are some caveats, life insurance benefits are generally not subject to taxes, meaning that your beneficiaries can keep every dollar of your policy’s proceeds, when they need it most.
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