Life insurance provides your family and loved ones with a vital financial safety net in the event of your death. But with a variety of life insurance policy options available, many people wonder exactly how to handle their policies when it comes to filing taxes. The good news is that in most cases, you do not need to pay taxes on life insurance. However, there are a few exceptions. So, to clear up some of your tax worries here is a quick primer on life insurance and taxes:
One common life insurance tax question has to do with whether or not policy premiums are considered a deductible expense. Unfortunately, the answer is no. Your life insurance policy is considered a personal expense, and therefore, your premiums are not tax deductible. This goes for all policies regardless of the provider. However, there are a few small exceptions. For instance, if your life insurance premiums are included in your alimony payments, they may be deductible.
Payouts to Beneficiaries
Again, in most cases, your beneficiaries will not have to pay taxes on the proceeds from your policy. However, if your estate is large enough to be taxed ($5.45 million and above), your life insurance benefits will be taxed as part of your estate unless, at least three years before your death, you transfer your policy to an irrevocable trust.
Another reason your benefits might be taxed is if your beneficiaries opt to take their payouts in installments, rather than in a lump sum. In this case, your insurance company would have to pay interest on the balance of your benefits, and that interest would be subject to income tax.NOTE: Payouts to spouses are exempt from taxation. So, even in the event that your estate is large enough to be taxed, your spouse’s benefits will be tax-free.
Permanent life insurance policies accumulate cash value over the life of the policy, which are not subject to income tax. And if you decide you no longer want your permanent life insurance policy, you can surrender it for a lump sum. However, if your surrendered policy has built up more cash value than you paid in, you would owe income taxes on the amount that exceeds your original investment in the policy.
If your insurance provider is a policyholder-owned mutual insurance company, you might receive annual dividends, which are not taxable unless the amount you receive is more than you’ve paid into your policy.
In short, the important thing to remember is that in the vast majority of cases, your life insurance benefits are not taxable and do not need to be included as income when you file your income taxes. Only in the event of interest accrual, or if the cash value of your policy exceeds what you paid in premiums, will you need to pay taxes on life insurance.