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As you review your life insurance coverage, it's smart to consider how taxes might affect any benefits you or your loved ones receive. For most people using life insurance as a financial cushion in the event a family member's death, taxes might not be an issue. But depending on how you use your policy, you could potentially face tax consequences.
So, how are life insurance payouts taxed when it comes to death benefits? Is the cash value of life insurance taxable? Here's what you need to know.
Understanding a Policy's Cash Value
Permanent life insurance policies typically include a cash value, which can be borrowed against and potentially used to pay the premium or purchase an annuity. The cash value has the potential to grow over time and accrue interest. Annual cash value growth in a life insurance policy is not usually taxable.
Withdrawals from a permanent policy can also be tax-friendly, but it's crucial to know the rules and review your strategy with a CPA before taking action. So, when is the cash value of life insurance taxable? Here are a few elements to keep in mind:
- Withdrawals: When you withdraw money from your cash value, you can generally take out an amount equal to your total premium payments without owing taxes. However, be aware that withdrawals could cause your policy to lapse, resulting in a loss of coverage. Once your withdrawals exceed the amount you've put into your policy, you would generally owe income tax on those withdrawals.
- Policy loans: If need be, you can tap the cash value of your policy and take out a loan. This type of loan may not generate a tax bill (unless it is considered a modified endowment contract, which would be taxable). However, if the policy runs out of money and lapses, you could owe taxes on any unpaid loan balance. Whereas withdrawals aren't paid back, loans can be paid back — and accrue interest until they are. Accordingly, outstanding loans can reduce your death benefit, so evaluate the pros and cons before borrowing.
- Cashing out: It's possible to cash out a life insurance policy if you need the funds or if you no longer want to keep the policy in force. This is also referred to as "surrendering." With a cash value policy, you can receive the cash value of your account plus accrued interest — minus the funds needed to pay any loans, unpaid premiums and surrender fees. You will typically see this as the net cash surrender value.
Are Life Insurance Payouts Taxed?
Beneficiaries who receive a death benefit as a lump sum typically do not need to pay income taxes on that payout. However, beneficiaries may have several options available to them, and they could owe taxes on any earnings from a life insurance payout.
Insurance companies often pay interest when beneficiaries refrain from accessing the proceeds of a policy. Those interest earnings are usually reported on each beneficiary's annual tax return and may result in taxes due.
Why Might Beneficiaries Leave Money With a Life Insurance Company?
For some, receiving a large amount of money — especially after the death of a loved one — can be disorienting. They may need some time to decide what to do with the money, so waiting can help beneficiaries avoid rash decisions. Insurance companies often pay a competitive rate on that money, too, so leaving it for a while may make sense.
Meanwhile, other people may choose to take periodic payments from the proceeds of a life insurance policy (instead of taking a lump sum). Also known as annuity payments, these payments can reduce the chances of beneficiaries spending all of their money too quickly. Plus, defined payments make it easy to budget during the coming months and years, potentially replacing the monthly income that the deceased family member once contributed. Just keep in mind that the interest portion of those payments would then be taxable when withdrawn.
Considerations Around Potential Tax Liabilities
There may be other situations that create a tax liability, although many people — especially those who use life insurance simply to protect against the loss of a wage-earning parent — are unlikely to meet those criteria. Still, it can be helpful to speak with your tax advisor and insurance professional before buying or changing a life insurance policy.
In certain circumstances, the death benefit that life insurance can provide may incur no taxes. Likewise, policy owners may be able to use the cash value from a policy without owing taxes. However, loans, withdrawals, and surrenders can potentially cause tax consequences, so it's critical to review your plans with a CPA. You may not be able to avoid taxes entirely, but avoiding surprises can make life easier for you and your loved ones.