Tax Treatment of Life Insurance Proceeds

by David Rodeck

    When you receive money from a life insurance policy -- whether it's a cash-value withdrawal from a permanent life insurance policy or a death benefit -- it's possible that the IRS could tax the proceeds. Whether you owe taxes on the money depends on your circumstances -- for example, how much money is in your estate.

    All life insurance policies offer a death benefit. This is the money that gets paid out when the insured person dies. When you are the beneficiary of the policy and receive money from a death benefit, you do not pay income tax on it. In exchange, the IRS restricts who can buy life insurance. You can buy life insurance only on a person whose death would hurt you financially. You can buy life insurance on a family member, for example, but not a neighbor.

    While the proceeds of a death benefit avoid income tax, they could be charged the estate tax. The IRS charges an extra tax on large inheritances. As of 2012, a person can transfer up to $5 million of property tax-free at his death. If he transfers more, anything over the limit gets charged the estate tax. This includes the death benefit of any insurance policies owned by the deceased. To make your proceeds tax-free, the insured must change the owner of his policy to someone other than himself. This means someone else besides the insured person has control of deciding who gets the policy's death benefit. If the insured lives for at least three years after the change, the death benefit will avoid the estate tax. Although this transfer could trigger gift taxes if there is cash value in the policy, the gift taxes will be lower than the estate taxes, because the future death benefit will be larger than any cash value.

    A permanent life insurance policy can offer cash value. This is money that you invest and can take out while you are alive. As long as you keep your cash value in your life insurance account, your investment gains are tax-free. When you make a withdrawal, you will owe income tax on your gains. You get back whatever you paid in premiums tax-free, but if you take out more than you paid in, you owe income tax on the gains the policy earned. This is true for both a partial withdrawal of your cash value as well as when you cancel the policy and take out all your money.

    Some people choose to take out their life insurance money in the form of a loan rather than a withdrawal. There is no tax on a loan. As long as you keep your insurance policy active, you don't need to pay back your loan. When you die, your policy's death benefit will pay off the loan, meaning you never pay income tax on this amount. The downside of this strategy is it reduces the amount of money your beneficiaries receive. It also forces you to keep paying for your life insurance as opposed to cancelling your policy and taking out all your money in a withdrawal.

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    About the Author

    David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.

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