IS LIFE INSURANCE TAXABLE?

There are many people who don’t know whether or not life insurance is taxable. Life insurance proceeds are not usually subject however, there are instances when life insurance can pay taxes. One of the primary upsides to life insurance is that the payout is made to your beneficiaries tax-free. Since life insurance death benefits can be in the millions of dollars, it’s a significant advantage to buying and receiving life insurance. But there are other aspects to life insurance that won’t get past the taxman. Here’s a look at when to prepare for a tax bill.

If You Withdraw Money from Cash Value

If you have a cash value life insurance policy, you can generally access the money through a withdrawal or loan, or by surrendering the policy and ending it.

One of the reasons to buy cash-value life insurance is to have access to the money that builds up within the policy. When you pay premiums, the payments generally go to three places: cash value, the cost to insure you, and policy fees and charges. Money within the cash value account grows tax-free, based on the interest or investment gains it earns depending on the policy. But once you withdraw the money, you could face a tax bill.

You Surrender the Policy

There can be times when a policy owner no longer wants or needs the life insurance policy. You can take the surrender value of the policy, and the insurer will terminate the coverage. The amount you receive is your cash value minus any surrender charge. You can generally expect to get a surrender charge within the first 10 or 20 years of owning the policy, and over the course of time the surrender charge phases out.

You won’t be taxed on the entire surrender value, though. You’ll be taxed on the amount you received minus the policy basis. This taxable amount reflects the investment gains that you took out.

You Took Out a Policy Loan and the Life Insurance Ends

If you have a policy with cash value and take out a loan against it, the loan isn’t taxable as long as the policy is in force. But if the policy terminates before you’ve paid the loan back, you could get a tax bill. For example, if you surrender the policy or it lapses, the coverage terminates.

The taxable amount is based on the amount of the loan that exceeds your policy basis. Remember, policy basis is the portion you’ve paid in premiums. Amounts “above basis” are based on interest or investment gains on cash value.

One way to access all your cash value and avoid taxes is to withdraw the amount that’s your policy basis, this is not taxable. Then access the rest of the cash value with a loan also not taxable.

You Sell the Life Insurance Policy

There’s a market for existing life insurance policies, especially cash value life insurance policies that ensure people who are terminally ill or have short life expectancies. Transactions involving terminally ill policy owners are called “viatical settlements.” These involve an investor, such as a company specializing in buying policies, paying you money for the policy, becoming the policy owner, and then making the life insurance claim when you pass away.