When most people think of life insurance policies, they think of the payout the beneficiary receives when the insured person passes away. In truth, life insurance comes in more than one variety, and some policies have monetary value beyond the death benefit, actually accruing cash value and even earning interest. These types of policies are used not only for life insurance but also for retirement savings. If you receive money from a life insurance policy, whether it's taxable or not will depend on where it came from.
Life insurance proceeds you receive when someone dies are generally not considered taxable income. However, if you have a life insurance policy with cash value and that policy issues you a dividend, you may have to pay taxes on any amounts above and beyond the premiums you paid. Further, any interest you earn on life insurance dividends or proceeds after you receive the money is taxable as interest income.
What Is a Life Insurance Policy?
A life insurance policy is an insurance policy that pays money to a beneficiary or beneficiaries upon the death of the insured. The insured can choose the amount she wants paid out when she dies, and then she can buy into a policy that will pay that amount. She chooses the beneficiaries and designates them to the insurance company; then she pays into the policy over the course of her life, and if she stays current on the policy, the insurance company will pay the beneficiaries the agreed upon amount. For example, you can find life insurance policies that will pay $50,000 upon your death to the beneficiary of your choosing. If you choose more than one beneficiary, you can decide how much of the benefit each person gets, so if you name your brother and sister as the beneficiaries but you want your brother to receive 75 percent of the money instead of splitting it 50-50, you can do so.
Term Life Insurance Policies: No Cash Value
Term life insurance policies are garden-variety policies with no cash value; you simply pay your premiums as you do with any insurance policy for a set term of years (often 10, 20 or 30). If you die during the term, the set benefit amount is paid to your beneficiaries in a lump sum. If the policy term ends while you're still alive, you have to pay higher premiums to keep it going. It never accumulates any cash value; that is, it isn't worth anything to anyone until you pass away.
Term Life Insurance Proceeds Are Not Taxable
If you're a beneficiary under a term life insurance policy and you receive the proceeds upon the insured's death, you will not be taxed on those proceeds. If your spouse, for instance, has a term life insurance policy through her job and you're the beneficiary, you'll not be taxed on the proceeds you receive if she dies before you, no matter how much that amount is. However, if you deposit that money into a bank account or investment account and interest accrues on the balance, that interest is taxable.
Permanent Life Insurance Policies: Whole Life Insurance
Whole life insurance policies are a type of permanent life insurance. They offer the same death benefit as term policies, but they also accumulate cash value and are in effect for the whole life of the insured and not just a specified term of years (hence the use of "whole" and "term"). The premiums for whole life policies are higher than those paid for term life policies. When you pay those premiums, however, they are accumulated and held for you as cash value rather than simply paying for the risk. This is why these policies tend to have higher premiums; essentially, you're "buying" the policy instead of "renting" the policy.
Permanent Life Insurance Policies: Universal Life Insurance
Universal life insurance is a type of permanent insurance that is similar to a whole life policy in that it has both a death benefit and a cash value, except that the cash value can be used to fund the policy as it accumulates and earns interest. The longer you pay in, the more cash value you accumulate and the more the policy can become self-funding (the insurer will use your cash value to pay premiums when you can't). When you retire, you can receive distributions from the policy on a regular basis, which then reduce the death benefit for your beneficiaries. For example, you might buy a policy that offers a $300,000 death benefit that can be fully funded over 30 years based on your monthly premiums. You designate your wife as your beneficiary, so if you die, she receives that $300,000. If you retire after the 30 years is over and start receiving distributions, the $300,000 will dwindle as you get paid, and if you die thereafter, the death benefit is reduced by your distributions. When you pass away, the cash value disappears, and the remaining death benefit goes to whomever you designated to receive it.
Participating vs. Non-Participating Policies
Whole life insurance policies can be either participating or non-participating. With a participating insurance policy, you, as a policyholder, are actually considered an "owner" of the insurance company. The insurance company will charge premiums based upon their projected expenses for the year. If the insurance company had a good year by making good investments or saving on expenses, they may return the excess to you as a dividend. Your specific policy will provide the details regarding dividends; some policies have an annual dividend provision, and some don't pay dividends consistently.
A non-participating policy, on the other hand, does not pay out dividends. Any excess remains with the life insurance company. Universal and term life insurance policies are generally non-participating because the policyholders are not "owners," and profits are paid to the insurance company's shareholders.
Life Insurance Dividends Are Only Taxable to an Extent
If you do have a participating life insurance policy and receive dividends from the life insurance company, you'll only be taxed on any portion of the dividend that exceeds the amounts you paid in, and on any interest that accrues after you deposit the money in your bank account. The IRS views these life insurance dividends as a refund of a premium and not as taxable income; therefore, if you paid $20,000 into the policy in 2018 and received a dividend of $1,000 at the end of 2018, that amount is not taxable. However, if you paid $20,000 into the policy and received a dividend of $25,000, you would have to report the $5,000 excess as taxable income. You would also have to include as taxable income any interest you accrue on the funds you receive.
Cash Value Distributions Are Taxed as Regular Income
Universal and whole life insurance policies' cash values grow tax-free. Once you retire and start receiving distributions, or if you cash in the policy early, you're taxed on those distributions as ordinary income, much like 401(k) distributions. However, you're only taxed on the portion of the distributions above and beyond the amount you paid in premiums. So if you paid $300,000 in premiums over your life and you cash out the policy for $324,000 due to interest earned, you'll only be taxed on $24,000.
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