Life insurance acts as a valuable financial anchor for the survivors of individuals who have passed away. In situations where the individual who has died was the financial "breadwinner" in a family, life insurance payouts can help sustain those who otherwise may find themselves in dire financial straits. Regardless of the size of the life insurance policy that has been purchased, the beneficiaries receiving the funds will typically not have to pay any income tax. That being said, there are certain exceptions to this rule, namely in scenarios where the life insurance payout is withdrawn in periodic distributions while interest continues to accrue.
With these ideas in mind, it is critical that individuals explore the various policies associated with their life insurance policy in order to ensure that they have the information needed to make smart decisions for the financial future of themselves and their loved ones.
In the majority of situations, individuals are not required to pay income tax on funds they receive as part of a life insurance payout. However, in the event that these funds have earned interest, income tax may apply to this additional income.
Exploring Tax on Life Insurance Payouts
The fundamental factor that will determine whether or not an individual is required to pay tax on life insurance payouts is how they elect to receive the funds in question. Life insurance beneficiary tax implications are directly linked to this particular issue. Federal and state governments will not charge taxes on life insurance payouts in situations where the individual holding the policy has died, and the sum of the policy is immediately distributed to the intended recipients. Where tax implications come into play is when the funds are not immediately transferred to the intended beneficiary. As mentioned previously, the specific size of a life insurance payout will have no effect on the tax responsibilities of the beneficiary in question.
Individuals have the ability to forego the traditional lump sum distribution and allow their insurance company to hold on to the bulk of the funds while periodic withdrawals are made. In a situation such as this, interest will begin to accrue on the nondistributed funds, effectively earning income for the beneficiary. Given the fact that this money was not originally part of the life insurance policy, the IRS will consider it income that is eligible for taxation as per standard income tax guidelines. It is important to note here that only profit from interest will be taxed rather than the principal life insurance payout balance still remaining with the insurance company. At no point can the principal balance be taxed due to the fact that, technically, it is already the property of the beneficiaries and is not being earned as income.
Researching Various Policy Options
Some life insurance holders find themselves wondering whether or not tax liability is incurred with specific policy options, such as term life insurance. Whereas permanent life insurance provides continuous coverage indefinitely as long as premium payments continue to be made, term life insurance, often referred to as "pure life insurance," only remains in effect for a designated period of time. Some individuals may elect to pay into a term life insurance policy while their children are enrolled in school so as to ensure their financial wellbeing in the event of unexpected death. With permanent life insurance, however, the coverage offered by the policy can remain in effect for decades if the policyholder chooses.
For either a term or permanent insurance policy, the named beneficiaries will not be required to pay taxes on money received if the payout is delivered in a lump sum. This tax immunity remains a consistent element of both plans, even though the specific details relating to their coverage differ significantly. With that in mind, when choosing the appropriate life insurance plan, you should factor in variables relating to your specific coverage needs and the length of coverage required rather than the possibility of tax losses.
Other Taxes on Life Insurance Coverage
When life insurance payouts are made to individuals, the only tax burden that may apply is income tax on interest earnings. However, in the event that a life insurance payout is made to the estate of a deceased individual, it is possible that this additional sum of money paid into the estate will elevate it beyond the minimum threshold for estate tax obligations. Currently, the exclusion threshold for estate taxes in tax year 2019 is $11.4 million dollars. In the event that a life insurance policy increases the value of an estate beyond this amount, the estate would be responsible for paying estate taxes on the remainder.
Generally, the scenario outlined above only occurs when the named beneficiary of a life insurance plan passes away before the policyholder. In a situation such as this, it is imperative for the insurance policyholder to name a contingent beneficiary. The opportunity to name a contingent beneficiary will be available during the creation of the life insurance policy.
Selecting a Life Insurance Policy
If you have any questions about the tax liability associated with your life insurance policy, your best resource will likely be the policy provider. These individuals can help you better understand how to avoid creating a taxable scenario following your passing. Your named beneficiary may also benefit from a discussion with the policy provider in order to help determine the most effective method for receiving policy funds at the appropriate time and avoiding tax payments.
For many individuals, determining the appropriate policy size is yet another significant concern. Again, this is a question that is best addressed by policy providers or an independent financial adviser. Based upon your current age and health, as well as your personal financial status, some policies may be more compatible than others. As always, due diligence and research will help you pinpoint specific policies that will provide you and your family with the best possible coverage.
More information about available life insurance policies can likely be found through the various providers offering such coverage today. You should always compare available policies and rates in order to find the best possible service offered that matches your budget and expectations. As always, thorough research yields the most consistently effective results.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.