Buying life insurance is one of the best ways to protect your loved ones. It also offers you the emotional benefit of knowing that those closest to you will be provided for after you're gone.
When purchasing life insurance, it's important to know that the proceeds will sustain your family for as long as possible. As with any significant financial decision, you'll need to understand the tax implications before making a commitment. So, is life insurance taxable?
In most circumstances, your death benefit, dividends and surrender payouts avoid taxation, but in some cases, there can be tax consequences. Here's what you need to know when it comes to life insurance and taxes.
Non-Taxable Events Related to Life Insurance
Generally speaking, life insurance is split into two primary categories: term and whole life insurance. Term life insurance covers you for a fixed period of time (like 20 years) before expiring, while whole life insurance lasts your entire lifetime.
In most instances, whether you've purchased a term or whole life insurance policy, the death benefit your beneficiaries receive won't be considered taxable income. Here are some common circumstances where they won't be required to pay taxes on your life insurance payout.
1. Death Benefit
In most situations, when you die, your life insurance payout will go to your beneficiaries tax-free. One exception is if your estate carries a value greater than $11,580,000 in 2020, per the IRS. In this case, the life insurance payout would be considered part of your estate, making it subject to federal estate taxes.
However, life insurance can go toward paying estate taxes. In that case, your beneficiaries wouldn't have to liquidate other assets or receive a reduced financial benefit.
2. Life Insurance Dividends
Some whole life plans pay policyholders a return on their premiums paid, commonly called life insurance dividends. These participating life insurance policies let you share in the profits made by the insurance company and receive those profits as if you own a dividend-paying stock. These dividends aren't considered taxable income unless they exceed the amount of the premiums you paid for the policy.
3. Surrender Payouts
Whole life insurance policies carry a cash value that builds over time as you make payments. If you decide to cancel or sell your life insurance policy, you become eligible for this cash value, minus any surrender fees outlined in your policy.
So long as the settlement value you receive amounts to less than you paid in premiums (and the total of any surrender fees), your surrender payout is tax-free.
When Is Life Insurance Taxable?
While you get to avoid taxation on life insurance proceeds in the situations described above, there are some instances where tax liability could be triggered. You could face taxes if you have:
- Interest earned from payout benefits.
- Profits earned from surrendering a policy.
- Any outstanding loans against your policy in excess of premiums paid in the event of surrender or policy lapse.
- Estate taxes on life insurance proceeds.
Drawing together two of life's certainties, death and taxes, means you must understand if and when life insurance is taxable to ensure your loved ones aren't left with any financial surprises. In most cases, your life insurance policy will be tax-free and can bring financial comfort to your family in their time of need. Upon your passing, your death benefit will be there for them almost immediately.
Buying life insurance offers a simple, encompassing message of support to those you care about the most. Take the time now to review which option can best fit your needs so you can establish a life insurance policy that will serve as the cornerstone of your retirement plan.