Is a Life Insurance Payout Taxable?
- Estate tax applies to any policy on which you hold ownership and may reduce proceeds by up to 45 percent. The way to avoid this is to transfer ownership of the policy to the beneficiary. You also may set up an irrevocable life insurance trust, which will hold the proceeds for the beneficiaries. However, you must establish the trust three years before your death unless your trust is named as the beneficiary.
- As long as you have transferred ownership of your insurance policy to your trust or beneficiaries, proceeds from the policy generally are tax-free income for the beneficiary. Proceeds are taxable only if proceeds exceed the value of the benefit. For example, if the face value of the policy is $500,000 and you get exactly $500,000 or less, you won't owe tax. If you get $550,000, however, the $50,000 extra is taxable income. This may happen if your life insurance has investment options.
- An insurance dividend is a cash value paid to your beneficiaries in addition to the face value of the policy. People usually set up cash value accounts on whole life insurance policies so that they can have a savings to pay premiums or meet other expenses. You pay extra in premiums to the company to establish the cash value account. After you die, the cash value account still is associated with the policy if you haven't used it, so you can distribute it to your heirs. Because you've already paid for the cash value through your premiums, cash value funds are not taxed. The first exception is if the cash value funds exceed the amount you've paid in premiums for the policy. The second is if the dividends are associated with a business policy and the business deducts the policy premiums on the company's taxes.
- Interest associated with life insurance proceeds is taxable income. You must report the interest as income either in the year it is credited or by a date specified for credit in the policy.
- If you have any questions about how to avoid taxes with your insurance policy, consult with your tax agent before purchasing coverage. If you already have your policy, your agent can tell you how to adjust the policy. Another resource is your insurance agent.