Is Life Insurance taxable?

Buying life insurance can help with unexpected expenses should you pass away. Whole Life insurance is intended to provide death benefit protection for an individual’s entire life. With payment of the required guaranteed premiums, you will receive a guaranteed death benefit and guaranteed cash values inside the policy to help pay bills, and even help pay off large expenses like homes or cars.

In addition to providing financial confidence, some life insurance policies can be an important part of an overall financial strategy. As with retirement accounts, there are tax implications to consider prior to making a final decision on life insurance.

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When beneficiaries might pay tax on the policy proceeds

Most of the time beneficiaries will not be required to pay income taxes when the beneficiary receives a death benefit¹. The money is not taxable income. There are a few situations, however, where the beneficiary may have to pay taxes on some or all of a policy’s proceeds.

Earned interest

If the policy holder has the life insurance company hold onto the benefit after death and the account has earned interest over that time, then the beneficiary may have to pay taxes on any interest earned during this period of time².

Is a life insurance payout, premium, benefits, income or proceeds taxable?

With life insurance, any interest that has been collected over time and has not been reported may be subject to being taxed. The rest of the benefit is not taxable. As an example, if someone has a $100,000 dollar policy that earns 10% interest for 1 year before being paid out, the beneficiary could be taxed on the 10%, or $10,000. However, they may not be taxed on the original $100,000³.

Some people may be hesitant to name a single person as their beneficiary, especially in a situation where the policyholder is a widow or a widower. In these situations, some policyholders opt for lumping their death benefit in with their estate. Even though this seems like it might be a helpful move because you are not leaving your benefit to a person, it may actually open up your benefit to being taxed through an estate or inheritance tax. This could typically leave a smaller benefit to your heirs and subject the money to the probate process subject to specific state laws⁴.

Is the cash value of life insurance taxable?

Cash value life insurance, also called permanent, or whole life insurance, is insurance that has real cash value that grows over time. The premiums of whole life insurance go towards both a death benefit and cash value that grows over time. With whole life insurance, you can borrow against or use in case of emergency⁵ subject to potential decreased death benefits, loan interest accruals and/or tax ramifications of a loan if a policy lapses.

The cash value of life insurance policies is generally not subject to income taxes as long as the money stays within the life insurance contract⁶. When the money stays in the policy it can grow tax-deferred, including on interest and dividends. You also have the ability to withdraw funds tax-advantaged as long as your withdrawals do not exceed your contributions.

How to choose a life insurance policy

As with any major life decisions, choosing a life insurance policy is nothing to jump into without doing some research first. It is important for you to know what each policy offers, and the benefits and potential drawbacks associated with the different types of life insurance. Once you understand how each policy works, you can make an informed decision and decide which policy fits your specific needs.

For life insurance, there are three basic types of policies that you can choose from.

• Term Life Insurance – this is life insurance that is provided for a specific length of time. When you purchase term life insurance you select a term, or length of coverage. Then, you pay a premium and in exchange for the premium your beneficiary will receive the full amount of your coverage if you pass away during the term.
  
  Term life insurance is typically a more affordable option than whole life insurance or universal life insurance because it provides no cash benefit if the term expires and you are still alive. Additionally, no loans or cash can be provided from a term life insurance policy, it is simply there to provide a benefit to your beneficiaries if you die.
  
  

• Whole Life Insurance – this is life insurance that is meant to last for your whole life. With whole life insurance there is a cash value component that increases as you pay each of your monthly premiums. As long as you keep paying the premiums, your beneficiaries will receive the death benefit when you die⁷.
  
  Whole life insurance also creates a pool of money that can be used in case of emergencies or opportunities. It can be borrowed against, giving you more flexibility than a term life insurance policy. Additionally, you can surrender your policy and take out the money that has built-up over time. With these additional benefits, whole life insurance is often much more expensive than term life insurance⁸.
  

• Universal Life Insurance – universal life insurance is similar to whole life insurance in that it is a cash value policy. This means that you can take money from the account or take out a loan against the account, subject to potential decreased death benefits, loan interest accruals and/or tax ramifications of a loan if a policy lapses. One major difference, however, is that the premiums tend to be lower and you can adjust your death benefit based on age.
  
  This type of insurance policy is usually purchased earlier in life to allow it time to accrue cash value. Some people will pay more into the account early in life so that they can use their cash value account to pay rising premiums as they age. Keep in mind, with permanent life insurance., one of the major drawbacks with universal life insurance is that your beneficiaries only receive the death benefit amount, and the insurance company keeps the cash value remaining.

No matter which policy is best for you, it is important to make sure that you are going with a reputable company with a track record of strength. Life insurance is a long prospect, potentially lasting 50 years or more. You want to make sure that you have a company that has a long track record of strength and who will be around for the long haul.

Is surrendering a life insurance policy taxable?

One of the benefits of a cash value life insurance policy is that you can use it as an emergency fund, or to simply help supplement retirement income later in life. You can take money out of your policy via loans, withdrawals or surrendering.

If you do choose to surrender your policy, it is important to know how the proceeds will be taxed. This is because those contributions have already been taxed. However, any interest or dividends that you may have received may be taxed as regular income⁹. Please check with your tax advisor to understand the taxation implications of surrendering a life insurance policy.

For example, pretend that you have paid life insurance premiums of $15,000. However, at the time of surrender your account value is actually $20,000 due to the accrual of interest. In this scenario you may only owe your regular income tax on the difference, which is $5,000 dollars.

What is a taxable benefit on a life insurance policy & insights

Purchasing a life insurance policy can be one way to ensure that your family and loved ones are protected in case of your death. As with all insurance policies, there are pros and cons to different types of policies. It is critical that you don’t rush into purchase life insurance without knowing all of the in and outs. Guardian Direct® has provided numerous resources for you to use to educate yourself on life insurance so that you can make an informed decision when choosing a policy that fits your needs from a carrier that you trust.

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