There are any number of questions that you should ask yourself before applying for life insurance.
Though many people tend to focus on questions related to health issues, overall eligibility, and coverage costs, few people stop to consider how life insurance affects their taxes.
Fortunately, the relationship between life insurance and taxes is mostly positive.
The bulk of the benefits from a life insurance policy simply aren’t taxable.
Since the goal of life insurance is to provide a financial cushion for your loved ones after you pass away, knowing the benefits aren’t taxable is a huge weight off your chest.
Of course, there are some exceptions to this rule.
Below we discuss life insurance and taxes, including when your benefits can be taxed and when they can’t.
Here’s everything you need to know about whether you life insurance will be taxable or not.
When is Life Insurance Taxable?
Because life insurance most often isn’t taxable, it’s easiest to start by looking at when it is, in fact, taxable.
The first, and most common, time life insurance is taxable is if your beneficiaries choose regular payments of the benefit over a lump sum.
A life insurance lump sum payment is almost never taxable (this is one of life insurance’s main selling points). Payouts over time, on the other hand, are taxable.
Still though, the tax on life insurance payouts is only on any accrued interest. It’s not on the original benefit (principal) amount itself.
This is happening because life insurance companies are paying interest on regular payouts. That interest then becomes legally subject to income tax.
#2 Loan Situations
Many life insurance policies allow their holders to take out loans. This is especially true of plans that include a cash accrual element.
You can borrow on the cash accrued at any time – however this is considered borrowing from the policy itself. You are required to pay back the amount you borrowed plus interest.
If you happen to die before the loan is paid back, you’re still on the hook. Or, rather, your family is on the hook.
Taxes are sometimes even applicable on this unpaid loan, and sometimes the entire benefit, in this situation.
Another situation in which life insurance is taxable is if you surrender a policy that comes with a cash accrual element.
Surrendering a policy sometimes enables the original policyholder to build up a higher value than the amount they originally paid.
If you do receive a payment for your policy which is larger than the amount you originally paid in, you’re on the hook for this growth in value, tax wise.
You must pay taxes on any income generated from this increase in value, at your nominal tax rate.
Still another reason why your life insurance might be taxable is if you sell your policy to another person. Known as a life insurance settlement, this agreement transfers your policy over to that person. They’re now on the hook for your payments, but also receive the full payout.
You are more than likely to pay taxes on any income paid from a life insurance settlement.
#5 Your Estate
A final situation in which taxes are owed on a life insurance payout is related to your estate taxes. If your life insurance payout is considered part of your estate, it can be taxed.
However, this final situation generally only pertains to the super wealthy. The reason is that your estate must be well over $5 million in total value for taxes to become applicable.
When Isn’t Life Insurance Taxable?
Despite the long list of situations described above in which life insurance is taxable, it’s actually not taxable most of the time.
What we mean is most people with a life insurance policy don’t fall under any of the specific situations outlined above.
Simply put, most people won’t pay taxes on their life insurance benefits.
In addition to the actual benefits remaining tax-free, any related cash value gains, surrender of payouts, and dividends also remain free of taxes while they remain in the policy.
However, it’s important to note life insurance and taxes can become a complex issue. It’s always a smart idea to run through your policy with a financial advisor, agent or accountant to ensure you won’t have to pay any taxes.
Avoid Taxes with Life Insurance
Buying a life insurance policy can actually help you avoid paying more taxes in certain situations.
Case in point: life insurance dividends, payouts, and cash value accumulation aren’t taxable most of the time.
The tax-free nature of these factors enable you to grow the value of the money you put into your life insurance policy without paying taxes on the growth. Much like a 401(k) or IRA, they gains are tax-deferred.
It’s possible to further protect yourself from taxes with careful planning. You can do this by creating an irrevocable trust.
An irrevocable trust is used to manage a person’s properties and businesses after they die by someone they choose. This life insurance trust can pay for all of these expenses related to their estate without being taxed.
Of course, using life insurance to avoid such taxes is a tactic which generally requires knowledge of both tax law and life insurance policies.
That’s why anyone interested in such tactics would do well to hire a financial advisor to help them create an effective, and legal, strategy.
Start Planning Now
You can rest assured going into a life insurance purchase that your new policy probably isn’t taxable if you don’t make any radical moves.
Pay into it each month and it should be paid out to your beneficiaries without being taxed upon your death.
Of course, there are other reasons to buy life insurance, beyond simply not paying taxes on your policy’s value.
These other benefits include helping your family after your death. A life insurance policy is designed to give them some financial cushion after you pass away, regardless of taxation; it’s all about paying less now for your family to get more later.
In addition to providing for income lost by your death, life insurance also covers your actual funeral and burial costs as well as any expenses related to grief counseling for your loved ones.
It’s important to note, all life insurance policies are different. That’s why it’s so important to do your research so you can find the absolute best one for you and your loved ones.
Buy the Best Life Insurance Policy
As mentioned above, it pays off big time to do your research.
You’ll soon see there’s a startling variety in the quality of service offered by life insurance companies, even those who offer relatively similar rates and policies.
Our thorough life insurance company reviews will help you see the pros and cons of the most popular companies, as well as exactly what type of products they offer, so you can make the best choice possible.
And, finally, we still recommend seeking out an advisor if you’re specifically looking to tailor your purchase for tax advantages.