The answer to that question is not as straightforward as you may think. Indeed, death benefits when they are paid out to named beneficiaries are not taxable. That’s one of the appealing things about life insurance benefits as an investment. However, there are several situations in which income from a life insurance policy may be subject to tax.
Taking Cash Out of the Policy
Whole Life and Universal life insurance policies include an investment component that many people find useful as tax shelters. The investment portion of these policies grows tax-free for the duration of the policy. When you pass on, the death benefit is tax-free. However, the investment portion may not be, depending on the beneficiary’s income level. Similarly, if you cash out all or a portion of the investment before the policy expires, the amount you take out will be taxed.
Taking a Loan
Many Universal life insurance policies allow you to take out a load against the value of the policy. Money taken out of the policy in this way is not taxed so long as you pay it back, and the policy is still valid. Once the policy lapses, is cancelled or sold, you’ll have to pay tax on the outstanding loan amount.
Selling the Policy
Believe it or not, there is a market for buying and selling life insurance policies. Sometimes people finding their life expectancy shortened due to illness sell their life insurance to free up money to pay for medical bills. Companies buy these policies and collect the death benefit when you pass on. The proceeds of the sale of the policy are not taxed by the IRS only if the policyholder is suffering from a terminal illness. Healthy people may also choose to sell their policy for a variety of reasons. Whatever the reason, proceeds of the sale are likely to be taxed.
No Named Beneficiary
In general, life insurance benefits are not taxed when paid out to the beneficiary named in the policy. However, if the beneficiary is deceased or the policyholder failed to name a beneficiary, the payout may end up in an estate subject to tax.
Before taking money out of the cash value of your life insurance policy, taking out a loan or selling your policy, talk to a knowledgeable tax preparer about the tax implications. Furthermore, keep your policy details up to date by ensuring that your beneficiary is valid and even naming a secondary. We are insurance and tax experts, so give us a call if you have any questions about life insurance and your taxes.
