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Life insurance is designed to provide a safety net for your loved ones when you die, a cushion upon which they can continue to lead normal lives without your income. While that can be a piece of solid financial planning, it can also leave families with a few nagging questions about the taxable value – and the post-tax value – of a life insurance policy’s payout.
If you’re the beneficiary of a life insurance policy and receive a payout after the policyholder dies, the proceeds usually aren’t considered income, and aren’t taxable, as the policyholder made post-tax contributions to the plan. However, sometimes money in life insurance policies remains with the insurer long enough to begin drawing interest, much like cash placed in a savings account. If you receive additional interest payments beyond the benefit amount, you must pay taxes on the interest, as the Internal Revenue Service classifies the interest as any other type of investment income.
Determining Taxable Portion
If you receive interest in addition to the benefit amount, you’re only taxed on interest portion of the payment. To determine the taxable amount, consult the policy to determine the amount payable; any excess amount is interest and taxed. If no value was stated in the policy, any amount in excess of the benefit’s stated value should be reported as interest income. For example, if a lump-sum’s benefit value is stated at $100,000, and you receive $115,000, the excess $15,000 is interest and is the only part of the payment that should be reported as income.
In some cases, the policyholder may name himself as the life insurance policy’s beneficiary, and the insurance company pays the benefits to his estate, rather than his survivors. Any interest earned on the benefit is taxed as income as if it were paid to a surviving beneficiary. The benefit is added to the deceased estate rather than going directly to a survivor, and may be subject to estate taxes if the total value of the estate and gift tax exemptions used during the deceased’s life exceeds $5 million. To avoid potential estate taxes on life insurance benefits, a policyholder should name someone other than himself as the beneficiary.
Cash Surrender Value
Sometimes, a policyholder chooses to cash out a life insurance policy before he dies if he’s made payments for several years. This cash-out payment is known as a policy’s cash surrender value, and the IRS treats it the same manner as if it were paid as a benefit. The cash contributions to the policy aren’t taxable as income – that money was previously taxed when it was earned – but any additional interest the policy may have generated is taxed as normal income.
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