Do Beneficiaries Pay Taxes on Life Insurance Proceeds?

January 18, 2018

You buy life insurance to protect your loved ones in the event that you pass away. You want them to be protected. But, what happens when they receive that money? Are the proceeds taxable? Paying taxes would certainly take away from the money they receive.

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Luckily, most proceeds are not taxed. There are exceptions to the rule, but a majority of the money beneficiaries receive is untouched by the government.

We look at the specifics below.

Standard Proceeds Payouts

Standard payouts to your beneficiaries remain untouched by the government. Your beneficiaries can receive the full amount you designated them to receive. The exception to this rule is if the payout becomes a part of your estate and your estate is large enough to be taxed. In 2017, the estate can be worth up to $5.49 million in order to remain untaxed.

Your beneficiaries have choices when it comes to payouts upon your death. They can take one lump sum, which remains untaxed, as we discussed above. They can also take the money in installments. In this case, they may pay some taxes. The interest they make on the money that remains untouched becomes a tax burden for them as it’s profit on top of the money you left them.

Spouses Never Pay Taxes

Luckily, no matter the size of your estate, your spouse will never pay taxes on a life insurance payout. This gives you the reassurance that your spouse will receive the full amount you purchase upon your passing. This is true even if the estate exceeds the $5.49 million threshold. The money you leave from a life insurance policy is excluded.

Cashing in a Life Insurance Policy

If you bought permanent life insurance, but then decide you need the money rather than leaving it for your beneficiaries, you have that right. You can cash the policy in without paying taxes as long as one condition occurs. You cannot make any capital gains on the investment. In other words, as long as you take out less than or equal to what you put in, you walk away tax free. If there are any capital gains, though, you will pay taxes – see below.

Capital Gains on Permanent Life Insurance

Here’s where the exceptions come into play. If you die and you have capital gains on your life insurance policy, your beneficiaries do not pay tax on it. However, if you surrender the policy before you die, you will pay taxes on the capital gains. You would owe taxes on any money you make outside of what you paid for the policy. This is an incentive to leave the investment untouched until your beneficiaries need it upon your death.

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Receiving Premium Dividends

Some permanent life insurance policies pay their insured dividends when certain situations occur. For example, if payouts were less than the company predicted for the year, they may pay dividends to policyholders. The amount paid to holders is generally not taxed. The threshold, however, is the amount of premium you paid. If your dividends received do not exceed the premiums you paid, you do not pay taxes. If, however, you receive more than you paid, it’s a capital gain and you’ll owe the IRS.

This is the case no matter how you receive the dividends. You often have the choice to receive it in cash, keep on deposit, or to use to buy more life insurance. No matter the choice you make, you won’t owe taxes unless the amount exceeds the threshold.

Taking a Loan on Your Life Insurance

If you have permanent life insurance, you have the option to ‘borrow’ your money. You then pay the money back as you would any other loan. You pay interest on the money borrowed. However, if you surrender the policy before you pay the loan back, you’ll owe interest on any money you receive that is above what you paid. Basically, any money you have in your pocket that exceeds the value of the life insurance policy becomes a tax burden.

Life insurance policies can help you decrease your tax liability in certain cases. Discuss your options with your insurance advisor to see how they may help you lower your tax liability while helping your loved ones in the face of your death.

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