Most people buy life insurance to provide their spouse or children with financial security when the wage earner dies. This is particularly important if children are young. Generally, beneficiaries collect the life insurance proceeds tax free. However, in a few different scenarios, some tax may be due on life insurance proceeds.
Generally life insurance benefits are not taxable to the beneficiaries. Benefits may be taxed when the proceeds become part of an estate large enough to be taxable. In addition, any interest paid on the benefits is also taxable.
Tax Benefits of Life Insurance
Life insurance can be simple or it can be very complicated. At its most simple, it is an insurance policy purchased by one person to benefit the person's family or loved ones. When the insured person dies, the policy pays death benefits to the persons named in the policy as beneficiaries. The original concept was that life insurance would provide financial security to a wage earner's family should she die.
In these circumstances, the spouse and family members named as beneficiaries of the policy do not have to pay tax on the life insurance proceeds. The exception is when the proceeds go to the estate and the estate is so large that the estate tax kicks in. But even when an estate is subject to tax, payouts to the surviving spouse are not subject to income tax.
Another tax benefit of life insurance applies to permanent life insurance policies that build cash value over the years. Those cash value account gains aren't taxable either. Nor are dividends. If a policyholder owns mutual insurance companies, they may give out dividends each year. But these dividends won't be taxable either, as long as the amount is less than the premiums paid in.
Instances when Life Insurance is Taxed
In a few situations, life insurance proceeds may be taxed. These are not situations most people find themselves in, and relate mostly to very large estates and sophisticated investors.
First, occasionally the death benefits pass into the estate. This usually happens when the policy's beneficiary precedes the policyholder in death and no contingent beneficiary is named. A very large estate may be subject to estate tax, including the benefits. Currently the estate tax applies only if the amount in the estate is over $10 million, so this is definitely a limited threat. The state estate tax amount may be smaller, however.
Second, the beneficiaries ask the insurer to hold the proceeds for a time after the death of the insured, or they may opt for installment payments instead of a lump-sum payout. If they earn interest on the proceeds value the interest is subject to taxation.
A third situation in which life insurance may be subject to tax is if you surrender a life insurance policy that has built up more value from investments than you paid in premiums. You would have to pay income tax on that excess amount.
Finally, if you sell your life insurance policy to another person while you are alive, the proceeds paid to the beneficiary at your death could be considered taxable income to that beneficiary. If you are considering this, seek advice from a tax professional.