Published: March 2016
When you purchased a life insurance policy, you likely took many things into consideration when choosing the amount of benefits. Life insurance can help replace income, cover college costs or pay off a mortgage if you pass away. You want to be sure your loved ones will have their needs met. But will your beneficiaries really receive that entire amount after you pass away? Or will they owe taxes on the benefits they receive from the policy?
The Internal Revenue Service (IRS) says benefits paid out from a life insurance policy are generally not subject to federal income taxes, provided they are received as a result of the insured person passing away. In that case, your beneficiaries would not have to report the amount or include it as gross income on federal tax returns.
However, any interest that beneficiaries receive in addition to the policy amount is considered taxable and should be reported to the IRS. If your beneficiaries receive the proceeds in installments that include interest payments, the amount of interest included in the payment is typically considered taxable income, says the American Institute of CPAs. For example, if your beneficiaries receive a total of $101,000 for a $100,000 life insurance policy, the $1,000 is taxable at their income rate.
State tax rules vary from state to state. A tax advisor or your state's tax agency can provide information on what benefits, if any, are taxable in your state.
You likely purchased life insurance with your loved ones in mind. However, if you opted up front for accelerated death benefits, the policy's proceeds may be available to you should you become terminally or chronically ill.Accelerated death benefit payments, in which you receive some of your own policy's proceeds, are typically excluded from taxable income if your condition is certified by a physician, according to Forbes. Limitations and exceptions may apply, so be sure to talk to your agent about what may be available with your specific policy. Your beneficiaries would receive the remaining amount of your policy benefits, which would also typically not be taxable.
If you have a permanent life insurance policy, you may able to borrow against the cash value that you have accumulated on your policy1. According to Forbes, these loans, as allowed by your policy, are typically not taxable to you. However, you will need to pay the loan back to the insurer, or you could be risking a reduced benefit amount for your beneficiaries.
It's important to keep in mind that, while life insurance benefits are generally not federally taxable, each policy and each state's tax rules may vary. While helping to protect your family with life insurance can be a comforting decision, it's also a good idea to consult with your agent as well as a tax or financial advisor if you have any questions.