Are Life Insurance Proceeds Taxable?
When you’re making end-of-life arrangements, one of the biggest questions that will arise is how to handle your life insurance policy. These policies are designed to help your family cover funeral expenses, as well as any other final expenses that may be unexpected. It can also give them a bit more of inheritance after you’re gone.
But you may find yourself wondering, “Are life insurance proceeds taxable?” Read on to discover the answer and how you can ensure your heirs get the best benefits possible.
How Life Insurance Interest Works
Before we get into whether you have to pay taxes on life insurance proceeds, let’s talk some about how life insurance interest works. Variable life, whole life, and universal life insurance policies all accumulate cash value as you continue to pay into them. This value comes from the premiums you pay each month and accrues interest over time.
Your premiums will generally get divided into three different categories: your death benefit, your insurer’s costs and profits, and your cash value. As you get older, less money will go towards your cash value and more will go towards your insurer’s costs. You can use this cash value to pay your premiums, supplement your income, and build investment accounts.
Interest Payment Taxes
Now that we understand a little more about how life insurance interest works, let’s talk dive into taxes. In general, you do not have to pay taxes on income that you receive from a life insurance benefit. However, you will have to pay money on any interest that has accrued on the life insurance policy over the years.
Let’s say, for instance, that after a loved one passes away, you don’t collect payment on their life insurance right away. Instead, you let that money sit for three years, gathering interest until you really need it. When you draw that payment, you’ll have to pay taxes on the interest that accrued during that holding period.
Estate Taxes vs. Insurance Benefit Taxes
Some people decide when they’re setting up their life insurance policies that they’ll designate their estate as the beneficiary. This may be due to questions over who will inherit what or because they want to avoid the taxation question. After all, an estate doesn’t pay taxes, so their heirs are free and clear, right?
In fact, designating your estate as the beneficiary of your life insurance policy could wind up costing your heirs more money. If they get the life insurance benefit directly, they won’t have to pay taxes on most of it. But if they get it through an estate, they’ll have to pay estate taxes, which can be as high as 40 percent.
Transferring Ownership to Avoid Taxation
There is a loophole you can use to help your heirs avoid having to pay taxes on your life insurance proceeds. You can transfer ownership of the policy before you die so that the benefit won’t be subject to federal taxation. This transfers the policy out of the scope of the estate and so avoids any estate taxation questions.
It is important to remember that the new owner of your policy will have to pay the premiums on it. However, you can give them up to $15,000 as a gift, so they can use that money to cover the premium costs. You will also be giving up all future rights to make changes to this policy, so be sure to pick a new owner who you trust.
Creating Life Insurance Trusts
If you don’t want to transfer ownership of your policy, you can also avoid taxation on your life insurance policy by setting up a trust. An irrevocable life insurance trust still removes you from primary ownership of your policy. However, it places that ownership in a trust, rather than passing it on to another person right away.
When you place your life insurance policy in a trust, the trust handles the premiums, rather than relying on the future owner of the policy to do so. You will still have some legal control over the policy, too. This can be a great way to give your heirs the full benefit of your policy when they may not be responsible enough to handle managing it on their own yet.
Life Insurance Living Benefits
As you may know, your life insurance policy doesn’t only pay out after your death. You can get some benefits from it while you’re still alive, including accessing a portion of your death benefits if you become chronically and/or terminally ill. The question is do you have to pay taxes on these benefits you pull while you’re still alive?
In general, you won’t have to pay taxes on any benefits you receive from your life insurance policy before your death. The government views you as the beneficiary of the policy in this situation and so handles the taxes the same way. This can be helpful when you’re facing down thousands of dollars in hospital bills and medical expenses.
Are Life Insurance Proceeds Taxable?
Life insurance can be a great way to ensure your family is taken care of after your passing. In general, the primary benefit from a life insurance policy won’t be taxed as part of your estate. There are some steps you can take to make sure this benefit isn’t taxed, including transferring your ownership to an heir or a trust before your passing.
If you’d like to discover more answers to questions like, “Are life insurance proceeds taxable?” check out the rest of our site at Life Plans.com. We have the coverage you need at prices you can afford. Use our life insurance calculator today and start planning for a better end of life.