Life insurance is important for every adult to have. It ensures that your loved ones will be taken care of when you die, now that they no longer have your income. It gives you the peace of mind that they will have what they need. But the ins and outs can seem complicated.
Everyone should do significant research on their policy. It is crucial to choose one that pays out a large enough amount, making sure your beneficiary doesn’t have to budget it too tightly. It should be enough that they feel comfortable that they can get back on their feet.
One question many people ask when taking out a life insurance policy is whether it is taxable. We’re going to dive into this question, as it is not as straightforward as you might think.
Will my life insurance be taxed?
The simple answer to this question is no. Life insurance payouts are not seen as a form of income. They are, after all, in place to keep your loved ones above water. The money is taking care of a need rather than coming in as a form of retirement plan or earnings.
As long as you keep paying your life insurance as normal, you won’t have to worry about it being taxed. However, there are cases when you may have to pay tax. The good news is that this is only if you take one of the following actions.
Your payouts come in installments
Beneficiaries can choose whether to get the lump sum all at once or smaller payouts in installments. If they get the lump sum, they pay no tax. However, since the insurer keeps the amount in interest-bearing accounts when paying out installments, the interest that accrues may be subject to tax. The capital itself is not taxed.
Your estate is worth $11.7 million
Your estate is generally exempt from taxes. When you die, your life insurance becomes part of your estate. The estate tax exemption is only up to $11.7 million. If your estate is approaching that number and the life insurance takes it over the line, your estate will be taxed.
Your policy belongs to someone else
Let’s say you are insured with the money set to go to your spouse. However, you are not the person who has taken out the policy. Rather, that is a third party. This is then considered a gift and subject to gift taxes. That said, gift tax will only come into effect if the value of your estate passes the $11.7 million exemption.
You surrender or sell the policy
If you surrender or sell the policy while you are alive, you may have to pay taxes on the refunds. You will only pay tax on the amount that your refunds exceed the policy basis. In other words, if your policy basis is $1,000 and your policy is worth $2,000, you will only pay taxes on the extra $1,000.
You take out a loan on the value
You can take out a loan on your life insurance policy if you need. But, if you do so and the interest exceeds the cash value of your policy before you repay it, the insurer may cancel your policy. In that case, you end up paying tax on the amount that exceeds the policy basis.
In summary, you won’t have to pay taxes on life insurance in almost every scenario. Only if you choose to take one of the above actions will you be liable for any taxes.