Is Life Insurance Taxed at Payout?

If you have a family, you may own or have at least considered the purchase of life insurance so your loved ones can maintain the same standard of living if you pass away. With some types of life insurance, you could also receive a payout if you decide you no longer need the coverage. In either case, you or you beneficiaries will be better served if you understand the potential tax ramifications.

Lump-Sum Payment

Life insurance supplies beneficiaries with the money they need, tax-free, to carry on with their lives, as long as they receive the proceeds in a lump-sum payment. For instance, if you're the beneficiary of a policy with a death benefit of $100,000, you can expect to receive the full $100,000 shortly after the death of the policyholder without any present or future tax ramifications. You can use the money as you see fit, such as paying off the mortgage, providing for your kids' education or eliminating credit card debt.

Installment Payments

You can also elect to receive the proceeds in regular installments to stretch the payments out over an extended period of time. Installment payments offer the benefit of providing interest income on top of the insurance proceeds. However, any interest you receive is generally considered as taxable income. For example, if you receive the $100,000 in installments of $5,000 per year over 20 years and are paid an additional $250 in interest per year, the $250 is taxable each year.

Cash Surrender

If you're the policyholder, you might decide at some point you no longer need the coverage. If you have a policy that accumulates cash value such as whole life, you may choose to surrender the policy and receive the accumulated cash value. In this situation, any amount you receive that exceeds the total premiums you've paid over time may be considered taxable income.

Viatical Settlement

A viatical settlement helps a terminally ill policyholder seeking an influx of cash to sell her policy to a third party. In return, the policyholder receives an amount that is greater than the policy's accumulated cash value, but less than the death benefit. As with a cash surrender, any amount received in excess of premiums paid may be considered taxable income.