According to the general rule, when a beneficiary of a life insurance policy gets the death benefit, this money is not taxable. Hence, the beneficiary does not have to pay taxes on the money received.
However, there may be instances in which the recipient is subject to taxation on a portion of the whole earnings.
Is the cash value of a life insurance policy deductible from taxes?
In the long run, whole life insurance and the majority of other permanent life insurance plans accumulate cash value. You may use them to withdraw or borrow after you've accumulated enough and while the policy is still in force.
The majority of this cash is tax-deferred. It means you only pay income taxes on it when you take money out of the policy. Even in that case, the IRS would only tax you on the amount that exceeds the policy basis.
As a result, as long as you remove less than the policy basis, the cash value is tax-free cash. Any withdrawals made in excess of the policy's base are subject to income tax liability. It is important to note that removing money from the policy's cash value affects the death benefit, resulting in a lesser payment to your beneficiaries.
If you overpay your life insurance premiums, the IRS may designate your coverage as a modified endowment contract or MEC. This implies that the Internal Revenue Service (IRS) taxes cash value withdrawals as income - even if you withdraw less than the insurance policy's base.
If you believe your coverage qualifies for MEC status, consult with a tax specialist.
Situations in which the cash value is subject to taxation
Although it is rare, accessing more than the policy basis might result in significant tax liability. So, it is important to understand how and when this can occur. Here are three scenarios to be on the lookout for:
You have decided to cancel your insurance coverage
In the event that you surrender a permanent life insurance policy, you are effectively terminating the coverage. The insurance company pays out the policy's cash value, less any surrender costs, to the beneficiary.
Taxation applies to the part of the cash value that exceeds the policy basis. For example, if you surrender a $10,000 policy with a policy basis of $5,000, the Internal Revenue Service (IRS) regards the extra $5,000 as income and taxes you accordingly.
The taxable amount comprises the investment profits you realize as a result of the insurance.
You sell the policy
Selling your life insurance policy to a third party — a process known as a life settlement — might provide you with more money than just surrendering it. This is due to the fact that the selling price of the policy is not limited to the cash value amount.
It rather depends on a number of criteria, including your life expectancy, the death benefit, and the cost of the premiums paid.
The Internal Revenue Service (IRS) assesses two kinds of taxes on life insurance policies. Both of these depend on the profits you make:
The amount of the cash value that exceeds the insurance basis is subject to income taxation. Capital gains tax is necessary on any further profits from the sale. This includes money received in excess of the cash value of the policy.
It may be more advantageous to trade in a life insurance policy as part of a 1035 exchange. It is a provision in the United States tax law that enables you to swap identical assets. In this way, you do not have to pay capital gains tax on the difference in value.
You get a loan against the cash worth of the insurance policy
Despite the fact that you borrow more than the policy's base, cash value loans are tax-deferred. This implies that you may borrow against your life insurance policy without incurring any tax consequences.
When interest accrues on a loan, the amount you owe may eventually exceed the cash value of the loan. At this time, you must return the loan, or the insurer may terminate your insurance coverage without notice.
The insurer will normally use the cash value to repay the loan if you cancel the policy. You will be liable for any amount that exceeds the policy basis. Hence, you will have to pay tax for it. This is where you may find yourself in difficulty.
Not only were you having difficulty repaying the loan, but you've also been faced with a significant tax obligation. It is important to note that if you die before paying off your loan, any remaining balance deducts from your death benefit.
How to be certain that your life insurance recipient does not have to pay taxes?
It is possible to improve the likelihood that your beneficiaries will not have to pay taxes. Here’s how to do it:
Designate at least one primary and one contingent beneficiary
Because a policy payment that goes to your estate may be subject to estate taxes, you'll want to be certain that you choose many beneficiaries.
Incorporating a minimum of one main and contingent beneficiary increases the likelihood that someone will be alive to receive the policy's tax-free death benefit.
Notify your beneficiaries
Many life insurance payouts go unclaimed simply because individuals are unaware that they have been designated as a beneficiary! Tell your beneficiary about your insurance policy and supply your insurance company's contact information.
Inform recipients of the tax benefits of receiving a lump sum payment
Unless you say otherwise, the recipient is free to choose how they would want to receive the money. When recipients want to receive the benefit in a lump sum, they will get a single payment. This way, they don’t have to pay taxes.
If a policyholder chooses not to have their death benefit paid out immediately but instead to have it kept by a life insurance company for a certain amount of time, the beneficiary may be required to pay taxes on the interest earned during that period.
In addition, when a death benefit goes to an estate, the person or individuals who inherit the estate may have to pay estate taxes on their inheritance. The best bet is to claim the benefit as soon as possible and get the lump sum amount!