Is Life Insurance Taxable?

If you’re thinking about purchasing a life insurance policy or expecting a payout as a beneficiary of someone else’s policy, you might wonder: is life insurance taxable?

In most cases, a life insurance policy isn’t taxable. However, certain conditions may cause the death benefit or other policy aspects to become taxable as income or part of an estate. Here are several questions to ask yourself to help determine whether your death benefit or life insurance is taxable.

How Will You Receive the Death Benefit?

If you’re a beneficiary, you usually get to choose how you receive the death benefit. Common options include:

• Receiving a single lump-sum payment
• Holding the proceeds in an account with the insurance company and withdrawing money as you wish
• Taking a regular series of periodic payments

So, is life insurance taxable in any of these cases? A lump-sum payment typically isn’t taxed. But if you keep your proceeds in an account with the insurance company or elect to receive periodic payments, your balance will accrue interest. Your lump-sum payment may also accrue interest if it’s delayed while the insurance company validates the claim. In all of these cases, the original balance typically isn’t taxed, but the interest you earn on it is taxable as income. The rate you pay depends on your marginal tax bracket.

That doesn’t mean you should avoid any payout option that creates a tax liability—just be aware of the tax implications and plan for them. If you don’t need the entire payout at once, you may be better off letting that money earn interest. However, consider other ways you could use that money as well, such as paying off debt or investing it.

Does Your Policy Have Cash Value?

Life insurance policies typically fall into two basic types: term or permanent. In addition to providing a death benefit, permanent policies accumulate cash value. You can withdraw from or borrow against the cash value in your policy. However, doing so may have tax consequences:

• Cash value withdrawals, either partial or complete surrenders, are taxable to the extent they exceed the premiums paid. For example, if you withdraw $30,000 from your policy’s cash value and the premiums you’ve paid total $25,000, then $5,000 is taxable as income.
• Loans generally aren’t taxable as long as you repay them before the policy lapses or is surrendered. If you surrender your policy while you have an outstanding loan, it’s treated the same as a withdrawal. Any amount above what you’ve paid in premiums is taxable.

Is Your Estate the Beneficiary?

It’s common to name several people as life insurance beneficiaries. However, sometimes it might make sense to leave life insurance to your estate rather than a living person. This can provide your estate with cash flow to keep a family business going, for example, or provide liquidity to prevent the forced sale of an illiquid asset. If doing so causes your estate’s total value to exceed the federal estate and gift tax exemption limit, it may be subject to estate tax.

Does Your Policy Pay Dividends?

Some permanent life insurance policies pay dividends, which are cash payments to policy owners. These are considered a return of premium and generally aren’t taxable. However, they may create other tax implications:

• If the dividends you receive exceed the amount of premiums you’ve paid, the excess is taxable as income.
• If you allow your dividends to earn interest, that interest is taxed as income.

Do You Have a Group Policy?

Generally, you pay for your own life insurance policy. However, you may work for an employer that provides life insurance as part of employees’ compensation package.

The IRS allows employers to provide up to $50,000 of term coverage without taxes to each employee through a group plan. Receiving a greater amount of coverage through your employer’s group plan may have tax implications:

• If your employer pays for the excess coverage, you’re required to include the premium amount in your taxable income.
• If you and your employer share the cost, only the amount your employer paid is added to your taxable income.

Understand Your Tax Implications

Because life insurance usually isn’t taxable, you generally don’t need to do any specific planning to ensure it isn’t. However, as noted, life insurance can have tax implications for policy owners and beneficiaries in some situations.

To learn more about life insurance’s taxability or to ask about your personal situation, reach out to a Colonial Penn representative.

Insurers and their representatives are not permitted by law to offer tax or legal advice. The general and educational information here supports the sales, marketing or service of insurance policies. Based upon individuals’ particular circumstances and objectives, they should seek specific advice from their own qualified and duly-licensed independent tax or legal advisors.

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