Death and taxes are said to be the only two certainties in life. Thankfully, when you apply for life insurance, you may be pretty certain that the payout will be tax-free. So how is life insurance taxed?
In most cases, life insurance payouts are tax-free. Taxes on a policy’s payment should be the last item on most families’ minds when it comes to protecting themselves with coverage.
Unless your policy is subject to a few very particular circumstances, your beneficiaries will get the entire payout in one single sum, with no deductions or costs (including taxes).
How is life insurance taxed?
The proceeds of life insurance are rarely taxed. However, there are a few instances where Mr. Clerk will deduct a small amount from the proceeds of a life insurance policy.
The majority of these incidents include the insured relinquishing the policy while still living, the policy lapses, or the insured taking out debt against the policy.
1. You Surrender the Policy
A policy owner may decide that they no longer want or need their life insurance policy. You can take the policy’s surrender value, and the insurer will cancel the coverage. Your cash value minus any surrender charges is the amount you receive. Within the first 10 to 20 years of owning the policy, you can expect to be hit with a surrender charge, which will gradually fade away over time.
However, you will not be taxed on the total surrender value. The amount you received minus the policy basis will be taxed. The investment profits that you took out are reflected in this taxable amount.
2. If You Took Out A Policy Loan And Your Life Insurance Expires
If you take out a loan against a cash-value policy, the loan isn’t taxable as long as the policy is in place. However, if the policy expires before you repay the loan, you may face a tax liability. For example, if you surrender or let your policy lapse, your coverage ends.
The amount of the loan that exceeds your insurance basis is used to calculate the taxable amount. Keep in mind that the policy foundation is the amount you’ve paid in as premiums. Interest or investment gains on cash value are used to calculate amounts “above basis.”
Withdrawing the amount that is your insurance basis — this is not taxable — is one strategy to get all of your cash value while avoiding taxes. Then take out a loan to get the rest of the cash value, which is also tax-free.
3. Modified Endowment Contracts
Single-premium perpetual life insurance contracts became popular following a 1986 change of the tax code that eliminated numerous tax shelters.
In essence, you paid a significant upfront premium in one single sum and were assured a set amount of life insurance. It was similar to a single-payment whole-life insurance policy.
The problem was that you could keep putting money into these plans, extending the policy’s length and payment. You could also take out a loan against the insurance policy’s value. This permitted people to invest millions of dollars in life insurance plans that functioned as bloated, tax-free private bank accounts.
Congress had to act to fix the loophole that single-premium policies had created. They passed legislation that designated any policy that failed to meet specific criteria as a “Modified Endowment Contract,” or MEC. The seven-pay test was the name given to this rule.
The 7-pay test limits how much money you can put into an insurance policy for the first seven years of its life. Your insurance becomes a MEC if you put in more money than the cap permits. If you take out loans against a MEC before 59, you will be subject to regular income taxes and an additional tax penalty.
Even if the policy becomes a MEC, the death benefit element of the policy is not taxable.
4. A Taxable Estate Is Created When A Life Insurance Payout Is Received
The majority of life insurance payouts are provided to life insurance beneficiaries tax-free. Where does the life insurance death benefit go if a beneficiary was not named or is already deceased? It becomes part of the insured person’s estate and may be taxable alongside the rest of the estate.
This might result in a hefty tax burden, especially if both federal and state estate taxes are applied. While federal estate taxes will not apply to the first $11.7 million in an individual’s estate (beginning in 2021), state estate taxes may have far lower exemption amounts.
Another unfavorable scenario is when an estate is below the exemption level but receives a big life insurance payout that takes the estate beyond the exemption threshold and into the taxable territory.
All of this might be avoided if both primary and contingent life insurance beneficiaries were named and kept up to date.
The payout will not be taxed for 99 percent of persons who purchase life insurance plans. Term life insurance policies almost invariably have tax-free payouts. Except in cases where the insured, the policy’s owner, and the policy’s beneficiary are all the same person. Alternatively, if the death benefit from the policy would push your estate above the estate tax threshold.
The rewards from permanent life insurance policies may be taxed. However, you should only use them as short-term loans from your insurance company if you want to take advantage of their capacity to accumulate value.