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Are life insurance payouts taxable? According to IRS, in general, life insurance payouts are not taxable because insurance payouts are not considered as gross income. It means that the death beneficiaries of your insurance policy will get the full amount. But there are some scenarios when tax is applied to insurance payouts. When it comes to taxation it gets complicated.

So, we do recommend that you contact tax professionals to get detailed information about your personal taxation.

Life insurance is a good investment for your family and children, as it provides financial security when the sole source of income has gone. Because no one wants to leave their family unprepared.

Also, check out: 6 Common Types of Insurance You Should Know About

Let’s explore the details of “When is Life Insurance Tax Free and When it’s not?

Life insurance beneficiary tax implications are linked to how beneficiaries decide to get the payouts. Whether immediate payouts or regular income or installments.

Two Major Types of Life Insurance Payouts Taxation

There are two main scenarios when tax is applied to life insurance payouts.

1) Interest Income

If you’re earning interest on your income, then interest is taxable. There are times when a policyholder can hold the payout for some time and in that period of time, interest is earned. It means when the beneficiary receives payout after a period of interest accumulation rather than the immediate payout, In this case, the death beneficiary has to pay taxes on this interest.

Sometimes, beneficiaries choose for regular income (incremental payouts). In this case, delayed payouts earn interest which is taxable.

For example, if the death benefit is $500,000 and it earned a 10% interest in the last year, then the beneficiary has to pay a $50,000 tax amount.

2) Estate Tax

You might have this question in your mind “Are Life Insurance Proceeds Taxable To The Estate?”, let me try to answer this question.

If the beneficiary dies before getting the payout and there are no other beneficiaries. In this case, insurance payouts are paid directly to the estate instead of the beneficiary.

And when the other person inherits this payout from the estate, he/she might be held taxable. Because life insurance payouts are now under estate taxes. This tax can be an estate tax or inheritance tax. Check out IRS for detailed estate tax information.

Now we are going to give you a summary of when insurance payout is taxable when it’s not, in bullet form so you can read easily.

When are Life Insurance Payouts Taxable?

The following are the scenarios when life insurance payouts are taxable.

  1. When You’ve Borrowed: If you have borrowed money against your permanent life insurance policy and it’s not paid back yet. If you have gained interest in that period of time, then you are required to pay taxes on the interest you earned along with the borrowed amount.
  2. When You Earn Interest: If the beneficiary decides to get regular income or installments over a period of time, and you earn interest in this period of time. Then the beneficiary is required to pay taxes on the earned interest.
  3. When Three Persons are Involved: As a general rule, when there are three persons involved in the insurance, then insurance payouts are taxable. Three persons mean, insurance provider, insurance policyholder, and the beneficiary.
  4. Surrendering Insurance Policy: Do you have to pay tax on cash surrender value? In short, the answer is “Yes”. If you have taken a payout from your cash value account and then you decide to surrender your life insurance policy, you may be held taxable. If the amount you received exceeds the premiums you paid over the life of the policy, you need to pay taxes on the extra amount you earned.
  5. Selling Insurance Policy: If you decide to sell your insurance policy, the buyer (usually investment company) will continue paying premiums and they will get death benefits from your policy. But the amount you received from selling your life insurance policy is taxable.

When are Life Insurance Payouts Not Taxable?

  1. Cash Value Gains: Permanent life insurance policies are designed in such a way that they build cash value over time. When your beneficiary gets this extra gain along with policy payout. He/she doesn’t need to pay tax on cash value gains.
  2. When Only Two Persons are Involved: As a general rule when there are only two persons (Insurance company and policyholder) involved, then there is no tax.
  3. Surrendering The Policy For Lump-sum: In case of permanent life insurance policy, if you decide to surrender your insurance policy for a lump-sum payment. If this payment is less than the amount you paid for the premiums and fee of the policy, then it’s not taxable.
  4. Dividends: If your mutual insurance company returns the money in the form of dividends, the amount you receive is not taxable as long as it doesn’t exceed the amount you paid for the premiums.
  5. Payouts to Your Spouse: No matter if your estate is large enough to be taxed, your spouse is always excluded from the taxation.

Key Takeaways

  • In general, life insurance payouts are not taxable as they are not considered as gross income.
  • If life insurance payouts are delayed and you earn interest in that period of time. In this case,  you need to pay taxes on the interest.
  • When you surrender your insurance policy and you have taken a payout. If the amount you receive exceeds the premiums you paid over the life, then the amount received is taxable.

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Disclaimer:

All the aforementioned information is collected through various sources. We do recommend you to contact your insurance provider and tax professionals for further information.

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References:

https://www.finder.com/are-life-insurance-payouts-taxable
https://www.investopedia.com/ask/answers/102015/do-beneficiaries-pay-taxes-life-insurance.asp
https://www.valuepenguin.com/life-insurance/life-insurance-taxable
https://www.daveramsey.com/blog/is-life-insurance-taxable