Must one pay the proceeds of life insurance to enjoy the additional benefits that come with the policy? A life insurance policy protects the life of the policyholder. There are different types of policies, including term life insurance, whole life insurance, and universal life insurance.
Although the aim is to insure your life, you may be required to pay tax under some circumstances. That is what you are going to discover in this article.
Why Are We Even Talking About Life Insurance Policies Taxability?
We are asking “are proceeds of life insurance taxable” because of the death benefit. A Death Benefit is the amount of money the life insurance company pays to the beneficiaries. The beneficiaries, in this case, are the recipients of the amount paid out by the insurer when the policyholder passes away.
Now, you are wondering if these beneficiaries are meant to pay taxes for the death benefit received.
We want to mention that the beneficiaries of a life insurance policy do not pay taxes on the death benefit.
The life insurance company may not have a direct role to play in this. But the possibilities of paying income taxes for proceeds from a life insurance policy may vary by state. In some states, you may be required to pay a tax if the proceeds aren’t paid out as a lump sum.
In some other states, beneficiaries are required to pay income tax for estate investments. The “taxman” will ask the beneficiaries to pay income tax if the policyholder named an estate instead of an individual as the beneficiary. Therefore, the estate as the beneficiary is considered an investment vehicle. Those who will inherit it will pay income tax.
How to Avoid Life Insurance Proceeds Taxable Income
Are the proceeds of life insurance taxable? No, they are not provided you didn’t invest in an estate or fail to meet the agreements in the contract.
You may be able to avoid paying income taxes on life insurance through any of the following strategies:
1. Avoid Life Insurance Income Tax by Earning Dividends
Most life insurance companies offer dividends to the policyholders. These are paid when the company had a “good year,” in terms of making more profits. Insurers can make such profits either by paying out lesser death benefits or making strategic investments in different asset classes.
As a dividend-earner, your income tax is not taxed. It may be a great idea to commit a part of your premiums to these investments and “run away from life insurance income tax.”
Exception: There may be an exception to this. Your income tax from dividend payouts will be taxed if your payouts are more than the annual premiums you paid to keep the policy in force.
2. Death Benefits are Not Taxed
Death benefits are not subject to income tax, so your loved ones wouldn’t pay that when you pass away. This is the easiest way to avoid paying income tax on life insurance.
3. Sell Your Life Insurance Policy
Don’t want to wait until you pass away for the death benefit to be paid out? You can hasten the process through what is called a viatical settlement. This type of payout is done by an investor or a third-party life insurance policy buyer.
The person buys the policy and pays you the money for the same. The person automatically assumes the position of the policyholder and will receive the death benefit when you pass away.
But why would you want to sell your life insurance policy? The two most common likelihoods are when you need money for urgent medical treatment or are terminally ill.
4. Surrender Your Life Insurance and “Walk Away”
You can simply surrender or give up your life insurance policy and become tax-exempt. This works perfectly for policyholders who don’t want to pay income tax.
How does life insurance surrender work? First, you will let your insurer know what you are planning to do. The insurer will consider the option and likely offer you a lump sum as payment. The lump sum is a one-time payment that covers the value of the policy at the time. On receipt, it is officially considered that the insurer is free to terminate the policy.
Any tax implications? No, you wouldn’t be asked to pay income tax on the cash value you surrendered. The only reason you may be asked to pay tax is if the cash value is higher than you already paid as a premium.
Factors Influencing Life Insurance Proceeds Taxable Income
Now, you may be asked to pay income tax on your life insurance policy for the following reasons:
1. Payout Goes to an Estate Instead of an Individual
It is common to make death benefit payouts to individuals who are the loved ones of the deceased policyholder. However, things can get complicated if the payout rather goes to an estate.
But why would that happen in the first place? Possibly, the policyholder wished the payouts are committed to an insured estate. On passing away, the insurance company makes the payout to the estate.
On the other hand, the policyholder may not have named an estate in the first place. However, at the time of passing away, the beneficiaries are unreachable, and the proceeds go to an insured estate.
A great idea to avoid this from happening is by setting up an Irrevocable Life Insurance Trust (ILIT). The Trust allows you to name the beneficiary of the death benefit.
Doing this helps the trust to regulate the life insurance premium payment until the end of the policy’s term. That way, you are literally “removed from the equation”.
2. Delayed Payout
Some death benefit beneficiaries delay the payout of the sum held by the insurance company. Probably, they are trying to avoid spending the entire amount. While that may be a wise way to spend money, it can accumulate income tax because of the interests earned over time.
Conclusion: Proceeds from Life Insurance Policy are Taxable in Some Cases
Your beneficiaries wouldn’t be asked to pay income tax on the death benefits paid out on your death. However, the proceeds of life insurance become taxed when the payout is delayed, when the cash value is higher than the premiums or when the payout is made to an insured estate.
