Is life insurance taxable? – Councilor Forbes


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One of the main advantages of life insurance is that the payment is made to your beneficiaries tax free. Since death benefits from life insurance can run into the millions of dollars, this is a significant benefit to purchasing (and receiving) life insurance.

But there are other aspects of life insurance that will not escape the tax authorities. Here is an overview of when to prepare a tax invoice.

You withdraw money from the cash value

If you have a cash value life insurance policy, you can usually access the money through a withdrawal or loan, or by surrendering the policy and terminating it.

One of the reasons to buy life insurance with cash value is to have access to the money that accumulates in the policy. When you pay premiums, payments are typically made in three places: cash value, cost to insure, and policy fees and charges. The money in the cash value account increases tax-free, based on the interest or investment gains it earns (depending on the policy). But once you withdraw the money, you might face a tax bill.

The money withdrawn generally consists of two parts:

  • The money from the premium payments you have made. This component of a withdrawal is not taxable. In the life insurance industry, this part is called the “base of the policy”.
  • Money from interest or investment gains. This part is subject to income tax. Your life insurance company will be able to tell you how much of a withdrawal is “over base” and taxable.

If your life insurance policy is a “modified endowment contract” or MEC, different tax rules apply and it is best to consult a financial professional to understand the tax implications.

You waive the police

There may be times when a policyholder no longer wants or needs the life insurance policy. You can take the cash value of the policy and the insurer will terminate the coverage. The amount you receive is your cash surrender value minus the surrender charge. You can generally expect to receive a surrender charge within the first 10 or 20 years of owning the policy, and over time the surrender charges gradually disappear.

However, you will not be taxed on the entire cash value. You will be taxed on the amount you received minus the policy base. This taxable amount reflects the investment gains you have withdrawn.

You have purchased a policy loan and the life insurance is terminated

If you have a cash value contract and take out a loan against it, the loan is not taxable while the contract is in effect. But if the policy ends before you’ve paid off the loan, you could get a tax bill. For example, if you surrender the policy or if it expires, the coverage ends.

The taxable amount is based on the loan amount that exceeds your policy base. Remember that the basis of the policy is the part you paid in the form of premiums. The “above base” amounts are based on interest or investment gains on the cash value.

One way to access your full cash value and avoid taxes is to withdraw the base amount from your policy – it’s not taxable. Then access the rest of the cash value with a loan – also tax-free.

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You sell the life insurance policy

There is a market for existing life insurance policies, especially cash value life insurance policies that insure people who are terminally ill or have short life expectancies. Transactions involving terminally ill policyholders are referred to as “viatic settlements”. These involve an investor, such as a business that specializes in purchasing policies, paying you money for the policy, becoming the owner of the policy, and then making the life insurance claim when you die.

Viatic settlements are typically used as a way for patients to get money for medical bills, especially when selling a life insurance policy means getting more money than just giving it away for it. the cash value.

Fortunately, the IRS does not consider any part of what you receive for a viaticum settlement as taxable. Under IRS Code 101 (g) (2), an amount paid by a viatic settlement provider is treated as a death benefit payment – and death benefit payments are not taxable.

A lifetime settlement is a similar transaction, but involves a policyholder who is not terminally ill. In these cases, the IRS does not consider the proceeds to be a death benefit payment. Some of what you receive may be taxable.

You are a beneficiary of life insurance that receives interest on a death benefit

Most life insurance payments are made in a single payment immediately after the death of the insured person. But some recipients choose to delay the payment, or choose to take the payment in installments over time. Where these deferred payments include interest from the life insurer, such interest may be taxable.

The life insurance payment goes into a taxable estate

Most life insurance payments are made tax-free directly to life insurance beneficiaries. But if a beneficiary has not been named or has already died, where does the death benefit for life insurance go? It goes into the estate of the insured and may be taxable with the rest of the estate.

This could create a large tax bill, especially considering federal and state property taxes. While federal inheritance taxes will not tax the first $ 11.7 million per person (in 2021), state property taxes may have significantly lower exemption levels.

Another possible unfortunate scenario is that an estate is below the exemption level but a large life insurance payment is made to the estate. push him over the exemption threshold in the taxable territory.

All of this should be preventable by naming both primary and subsidiary life insurance beneficiaries, and keeping those selections up to date.

Summary: When is life insurance taxable?

Life insurance tax faqs

Are life insurance premiums taxable?

The life insurance premiums you pay are not taxable. They are also not deductible on your tax return.

Do you pay inheritance tax on life insurance?

There is no inheritance tax on life insurance. Life insurance death benefits are paid tax-free to beneficiaries of your life insurance.

Is there a penalty for cashing out life insurance?

If you drop a life insurance with cash value Politics, the only “penalty” is that you may have to pay a redemption fee. The life insurance company will deduct the surrender charge when it sends you the money. Check your policy for charges or ask your life insurance agent. The surrender of a policy terminates the life insurance coverage. Some of the money you receive may be taxable if it includes investment gains.

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