Taxes on Life Insurance Benefits

Life Insurance Tax Shelter

“The only sure things in life are death and taxes.” This statement is accurate, but whether taxes are paid on a death benefit is not. There are instances when life insurance policies or proceeds become taxable, so it is important that policy owners and their beneficiaries be aware that a taxable event may occur in conjunction with life insurance.

Death Benefit Tax

The death benefit itself is generally not taxable income. Whether the benefit is paid out in a lump sum or in installments is immaterial. The only amounts included in gross taxable income are those payments received that are more than the amount of the life insurance death benefit and payable to the beneficiary at the time of the insured’s death. If the death benefit of a policy is $100,000 and is paid in a lump sum, but the beneficiary receives $105,000, the beneficiary pays tax on the $5,000 as taxable interest earned. The $100,000 death benefit is not taxable to the beneficiary. If the death benefit and amount paid are the same, there is no taxable income to the beneficiary.

If a beneficiary elects to receive installments of the death benefit, they can exclude the portion of each payment from their taxable income. According to wwwebtax.com, beneficiaries should “divide the life insurance death benefit of the policy by the number of years of payments are to be received.” This is the amount that is tax free each year.

If the policy pays dividends, these are generally tax free to the policy owner. Dividends are the return of premiums paid and they reduce the cost of the policy. Dividends are not taxable until such time that they exceed the net premium paid on the life insurance policy.

Beneficiary and Taxes

Federal or state estate taxes could be due if the policy owner is the same as the insured. A policy owner is the person who has the right to change beneficiaries, coverage amounts or cancel the policy. The death benefit is taxable to the estate of the policy owner unless the beneficiary is the surviving spouse who is a US citizen. Death benefits paid to a child, sibling or other beneficiary are included in the estate and are taxable regardless of whether the policy proceeds pass through the estate. If there is no beneficiary, the death benefits are payable to the estate and are subject to estate taxes as well as inheritance taxes.

The final taxable event is the withdrawal of cash value. Any amount withdrawn from the cash value that exceeds the premium paid is taxable as ordinary income.

While taxes may be a certainty of life, the taxation of death benefits from a life insurance policy does not need to be. Consulting with a life insurance agent or financial planner while setting up life insurance policies help ensure that the investment provides protection without giving the government money.