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- Are life insurance proceeds taxable or tax-free?
- October 3, 2013 4:04 PM
Although most income you receive is taxable, which must be reported on your federal income tax return, there are some instances when income may not be taxable.
A major benefit of owning personal life insurance is that beneficiaries can receive the payout income tax free. This assumes that the insured/policy owner bought the personal policy and paid for it with personal, after-tax dollars. If the premium was paid by a corporation, who then deducted the premium as a business expense, then the proceeds might be taxable to the beneficiary.
Generally, life insurance death benefits are paid out to a beneficiary in a lump sum, which are not included as income to the recipient of the life insurance payout unless the policy was turned over to you for a price or unless the policy was owned and paid for by a corporation that deducted the premiums as a business expense.
Endowment contracts, worker’s compensations insurance contracts, employer’s group plans or accident and health insurance contracts also fall under this tax-free exclusion.
A major advantage of buying cheap term life insurance for individuals is that beneficiary proceeds are exempt from income taxes (although the proceeds might increase the size of the beneficiary’s estate).
This means that the financial leverage on the purchase of a term life policy can be enormous since life insurance premiums are at all time lows..
For example, a healthy 45 year-old male can buy a $1 million term life policy for about $50 per month. If that insured dies, his beneficiaries would receive $1 million free of all income taxes. This kind of premium-to-payout leverage is the reason why so many financial planners now recommend that family breadwinners carry no less than ten times their annual income in life insurance.
“The death benefits of life insurance are almost always free of state and federal income taxes when they are paid to the beneficiary. Most times the proceeds can also be free of gift and estate tax,” says Brian Ashe, treasurer for the Life and Health Insurance Foundation for Education (LIFE), a nonprofit organization that is focused on educating the public about insurance.
“For example, if I have a ‘permanent’ life insurance plan like universal life or whole life, under current law the cash values accumulate on a tax-deferred basis, so I can access those values with no tax if I only withdraw an amount equal to what I have paid in premiums and then borrow any amount over my ‘cost basis’ and have my cash grow tax-deferred. If the policy matures as a death benefit, I can have the remaining death benefits paid tax-free to my heirs” Ashe explains.
Life insurance can also be used to supplement other savings vehicles such as corporate pensions, IRAs, investments and social security proceeds.
Another advantage is that in most states the policy values of life insurance are creditor protected and if the beneficiary other than the “estate” is named, proceeds can escape probate.
For more information on this topic, consult with a qualified life insurance professional or visit the IRS website.
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