Life insurance is a great way to leave a safety net to your loved ones.
But will that money belong solely to them? Is life insurance taxable?
Coping with the death of a loved one is never easy. But in addition to the emotional turmoil you may be feeling, there are often financial problems as well. Your surviving family members may need help paying for funeral costs, offsetting lost income, and adapting to the inevitable change in their lifestyle.
Life insurance helps alleviate much of this anxiety, but it can bring up an interesting, yet valid, question: Is life insurance taxable?
In most cases, life insurance isn’t taxable as it’s not counted as gross income. However, there are cases where it is. This usually comes down to how you classify your beneficiaries and how the life insurance proceeds are made.
Let’s explore some scenarios where life insurance would, and would not, be taxable.
Who Should Have Life Insurance?
Life insurance is an agreement between an insurer and the policyholder, in which the insurer agrees to pay an amount of money to a selected beneficiary after the insured person’s death.
Other circumstances, such as terminal or severe illness, may also trigger payment based on the contract. The policyholder normally pays a premium, either regularly or in one lump sum.
Our expert opinion is that everyone should have a life insurance policy.
Life insurance is the best way to make sure your surviving dependents have a safety net to prepare for your unexpected passing. Even if you don’t have dependents, life insurance proceeds can help pay for any outstanding debt (including funeral costs).
Who Can Be Your Beneficiary?
Every life insurance policy has an assigned beneficiary, which can be a person, several people, or even an organization. The beneficiary receives the benefits upon your demise.
In most cases, you will pick a primary beneficiary as well as a contingent beneficiary/ies who will receive the death benefits if the primary beneficiary isn’t available.
Keep in mind that while you can choose who your beneficiaries are, children under 18 cannot be named as beneficiaries on a life insurance policy.
When Is Life Insurance Taxable?
You do not have to pay taxes on life insurance proceeds as long as they are paid out totally as a lump sum, one-time payment. However, if the policyholder chooses to spread the payout over time, the beneficiaries pay taxes on any interest earned during that time.
If you want to maximize the tax-free possibilities of a death benefit, you must understand how your insurance should be structured.
Taxable to the Policyholder
If you have a whole or permanent life insurance policy, you can access the cash value of that policy by taking out a loan.
The loan is generally tax free if you agree to borrow against the cash values of the insurance. If the loan is not returned before your death, the life insurance death benefit will be reduced by the loan amount.
Another benefit of a whole life policy is that, if you decide to surrender your policy altogether, you may be able to receive the entire cash value of the policy. However, there are tax implications to this, as you may have to pay taxes on the amount you receive.
Taxable to the Estate
What happens if the policyholder does not specify an individual or trust as the beneficiary of their insurance policy? In that case, the death benefit will be given to the policyholder’s estate, and any profits of the policy may be liable to federal estate tax.
If the insured’s spouse is specified as the beneficiary of the life insurance policy, the death benefit funds might also become part of the insured’s estate. The death benefit will form part of your spouse’s liquid assets when your spouse gets them. They can then be invested or preserved.
When that spouse dies, and their assets are transferred to their estate, the profits of your death benefit will be included in their total estate and may be liable to federal estate taxes. The simplest method to avoid this is to put your policy in an irrevocable life insurance trust. Life insurance trusts can not only reduce your tax implications, they can give you a certain level of control over how your assets are distributed after your death.
Taxable to Beneficiaries
If the beneficiary is a co-owner on the policy, that person has an incident of ownership interest in your cash values. As a result, when benefits are provided, they may become part of that person’s taxable estate.
You can avoid this by retaining ownership of your insurance or placing it in a trust.
When your life insurance death benefit is distributed, your beneficiaries will be asked to select a payment method. They can have the insurance company make payments in installments or as a lump sum, which is a one-time payment that covers the entire death benefit.
When the death benefit is paid in installments, the policy continues to generate interest. Any percentage of an installment received via this continuing interest accrual may be taxed.
When a lump sum payment is made, if your beneficiary invests the lump amount and generates a profit, they may be subject to a short or long-term capital gains tax when they sell the asset. They may also be taxed on dividends and interest earned by the investment.
What Can Your Life Insurance Go Toward?
A life insurance payment will give much-needed financial help if you lose a spouse or partner. When it comes to where your life insurance benefits can go, you have numerous alternatives.
Inheritance
Many people choose to get life insurance as a way of leaving an inheritance to their loved ones. However, this is not the same as leaving someone money in your will.
For one, your beneficiaries do not have to pay inheritance taxes on any life insurance proceeds they receive from you.
Secondly, life insurance death benefit does not have to go through the probate process. If you want to leave your loved ones with a financial benefit without hassle (or without having to save a vast amount of money yourself, life insurance can help.
In other words, regardless of what happens to your estate, your beneficiaries can be compensated.
Paying Off Debt
Whether you have credit card debt, personal loans, or high-interest student loans, your death will not automatically discharge your debt. A life insurance payout can help relieve the burden on your family members.
Education
Like most parents, you’ve probably spent some time thinking about your kids’ college fund, and life insurance is an excellent way to help pay for that.
Life insurance proceeds can also help surviving spouses pay for the education to reenter the workforce, change careers, or increase their earning potential.
Charitable Contributions
When people think about giving to charities, life insurance is sometimes ignored as a gift choice, but it may be a valuable method to provide charity money for future activities. So, giving a life insurance policy as a present would be something to think about.
Paying Federal or State Estate Taxes
Not only is a one-time life insurance payout not part of your taxable estate, you can actually use the money to offset other tax payments.
If you anticipate having to pay a gift tax or inheritance tax to pass your estate to your children, life insurance can be used to help cover the costs.
Let Harry Levine Insurance Find the Right Life Insurance Policy for You
Any wise financial and long-term planning should start with purchasing life insurance as soon as possible. It is often one of the more affordable insurance policies on the market and allows us to ensure our loved ones are still taken care of after we’re gone.
However, simply having a life insurance policy is not enough. There are many different types of life insurance at varying levels of coverage, so it is important that you find the one that best fits your needs.
We know that life insurance can be confusing, overwhelming, and—in many cases—difficult to think about. Yet purchasing a life insurance policy is one of the best things you can do for your loved ones. If you still have questions regarding life insurance coverage, an independent insurance agent can help you pick the policy that best for you.
Contact Harry Levine Insurance to discuss your plan options and get a free life insurance quote.
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