When you purchase life insurance, you are investing in the peace of mind that comes with knowing your loved ones are protected if you were no longer able to pay the bills. You might be wondering what the payout of your life insurance policy will actually look like — will Uncle Sam take a percentage of the death benefit? Read on to learn more about how life insurance proceeds work.
Life insurance proceeds are usually not taxable
If you pass away while your life insurance policy is active and premiums are paid, your life insurance policy provides a death benefit to your chosen beneficiary. With this lump sum, your loved one can continue their standard of living, pay off debts, or continue to pay the mortgage. These benefits are income-tax-free to recipients, so your beneficiary will receive the full amount without paying taxes.
A few exceptions
There are a few cases where some of the life insurance proceeds from permanent life insurance policies might need to be reported for tax purposes. If your beneficiaries decide to receive their payout in periodic installments rather than a lump sum, they could earn interest on the undistributed portion as it sits with the insurance carrier. The portion that collects interest will be taxable income for your beneficiary.
Another instance where your portion could be taxed comes up when your whole life or universal life insurance policy accumulated a cash value that was greater than what you paid into the policy in premiums. If this occurs, a portion of the cash value paid to your beneficiary might be counted as taxable income.
The third scenario in which your payout could be taxed relates to unpaid policy loans. If you have a whole life or universal life policy, you have the option of borrowing money from the cash value of the policy throughout the time it’s active. If you surrender your policy or it lapses while you have an outstanding loan balance that is greater than the amount you paid into the policy, you will have to report income and pay taxes.
What about estate taxes?
Your life insurance payout is considered a part of your overall taxable estate when you pass away. However, most of us are not subject to federal estate taxes, as most individuals can exclude about $10 million (indexed for inflation) and couples can exclude $20 million from federal estate taxes. While you might be subject to state taxes, you will most likely not need to pay out a federal estate tax.
If you haven’t already, apply for life insurance while you’re young & healthy
The fact that life insurance proceeds are not taxable can be a significant benefit for you and your loved ones. This payout can be used to ensure your loved ones can continue living in their home and paying the bills if you are no longer around to provide for them.