Life insurance can give your loved ones financial security should you die. In most cases, life insurance proceeds are not taxable, so your beneficiaries should get the full amount available under your policy.
There are certain circumstances in which life insurance benefits may be taxable, but generally they apply only to permanent life insurance policies, such as whole life, or to individuals with very large estates.
When life insurance isn’t taxable
One of the big selling points of life insurance is that the proceeds are rarely taxable, including in these situations:
- Payouts to beneficiaries: The main reason to buy life insurance is to provide a payout to your beneficiaries after your death. Beneficiaries will not have to pay taxes on what they receive, unless the proceeds become part of your estate and your estate is large enough to be taxable (more on that below).
- Payouts to spouses: Even when an estate is large enough to be taxed, payouts to spouses are excluded from estate taxes.
- Cash value gains: In addition to providing a payout if you die, permanent life insurance policies build cash value over time. The gains in the cash value account are not subject to income tax.
- Surrender payouts: If you decide you no longer want your permanent life insurance policy, you can “surrender” it and receive a lump sum. You won’t owe taxes as long as the surrender payout is less than what you paid in.
- Dividends: Mutual insurance companies, which are owned by policyholders, may give some money back to policyholders each year in the form of dividends. These dividends are not taxable as long as the amount isn’t more than you’ve paid in premiums.
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When life insurance is taxable
- Interest on payouts: Instead of taking a payout as a lump sum, your beneficiaries may elect to take the money in installments over time. In that case, the insurance company would also pay interest on the balance, and that interest is subject to income tax.
- Profit from surrendering a cash value policy: If you surrender a life insurance policy, it may have built up more value than you paid in, thanks to investment returns. In that case, you’d owe income taxes on the amount of the payout that exceeds what you paid in.
- Unpaid loans against your policy: If you have a permanent life insurance policy, you can borrow against the cash value you’ve built up. But you need to pay that money back, with interest. If a loan is still outstanding and you surrender the policy or the policy lapses, you’ll owe taxes on any loan balance that exceeds what you paid into the policy.
- Estate taxes on life insurance payouts: Although payouts to beneficiaries are not subject to income taxes, they can be considered part of your estate. If your estate is big enough to be taxed, that will apply to the life insurance payout as well. The estate tax applies to estates worth over $5.43 million in 2015, going up to $5.45 million in 2016. One common tactic to avoid this tax is to transfer the policy to an irrevocable trust. That keeps the insurance proceeds from becoming part of your estate. Note that if a policy is transferred less than three years before your death, it would still be subject to the estate tax.
- Profit from life insurance settlements: In a life insurance settlement, you sell your policy to someone else, with the buyer taking over premium payments and getting the payout when you die. In this case, the proceeds you get from the sale could be taxable. The tax treatment depends on the type of insurance policy, whether it has any cash value, how much you paid in and how much you received in the sale.
Using life insurance to avoid taxes
The fact that life insurance dividends, cash value accumulation and payouts generally are not subject to income taxes makes permanent life insurance policies attractive to wealthy people who are looking to avoid paying Uncle Sam. The ability to avoid estate taxes by combining life insurance with an irrevocable trust is another benefit. Some wealthy people use a life insurance policy in a trust to provide funds that their heirs can use to pay estate taxes on other assets, such as property or a business.
If this sounds appealing to you, consult a financial advisor. An advisor can help you do everything right, with your policy producing the tax benefits you want and protecting your loved ones according to your wishes.
If you’re looking for basic term life coverage, which is best for most people, NerdWallet’s life insurance rate tool offers an easy way to compare rates.