Are Life Insurance Policy Loans Taxable
In some cases, you might find the need to borrow against the value of your life insurance policy. To determine whether this registers as a taxable event, you will need to figure out how the amount borrowed relates to the premiums you have paid on the policy. Specifically, the money borrowed against the insurance policy does not incur a taxable consequence so long as it is equal to or less than the sum of the insurance premiums you have paid on the policy.
On the other hand, you will have a taxable amount equal to the size of gain you realize, which equals any amount you received from the cash value of your policy minus the net premium cost. This would normally be equal to the amount of premiums paid less any distributions you have received.
For example, imagine you carry a life insurance policy with
- a death benefit of $500,000,
- with $100,000 in premiums paid to date and
- a policy loan of $200,000 without any distributions.
In the event your policy lapses, you will need to claim $100,000 as taxable income .
Is Life Insurance Tax Deductible
Typically, life insurance premiums are considered a personal expense. Because of this, life insurance premiums are not tax deductible. However, there are a variety of tax benefits to having life insurance.
There are deductions if you are a business owner, and you have business-paid premiums. Also, the tax deferred cash growth of the policy is not subject to taxing through government regulation either.
This means the cash value of your life insurance plan cannot be taxed while it is growing. This allows you to collect higher interest rates and avoid money being taken out.
A Look At When You Might Owe Money To Uncle Sam
It’s important to consider the tax implications when you’re buying life insurance. The Internal Revenue Service imposes different tax rules on different plans, and sometimes the distinctions are arbitrary. The following guide is meant to help explain some of the tax implications surrounding life insurance premiums.
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Earnings From Investing Or Saving The Payout
Lets say you split up your $300,000 insurance payout and invest half of it in stocks and save the other half in an interest-earning savings account. Any interest you earn must be reported on your tax return. Likewise, if your invested money increases in value from $150,000 to $180,000 and you sell your stock, youll pay taxes on the $30,000 you gained if your taxable income is $78,750 or higher, in most cases. The only part of the insurance payout thats tax-free is the value of the policy on the date of death, according to the IRS.
Naming Your Estate As The Beneficiary
If you name your estate as the beneficiary. The estate will distribute the death benefits according to the terms of your will. The proceeds of the death benefit will become part of your estate and will be subject to estate taxes. If the death benefit is part of your estate, creditors may claim the death benefit to pay for your outstanding debts.
If you name your estate as your beneficiary:
- the death benefit will become part of your estate
- the death benefit will be distributed according to the terms of your will
- the money will be subject to taxes when your estate is settled
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When In Doubt Seek Expert Advice
In most cases you don’t have to pay taxes on life insurance proceeds, but if you have any doubt, the best course of action is to seek professional advice. In many cases, a qualified tax professional may be familiar with your scenario. This removes ambiguity from your tax preparation and better ensures you don’t end up on the wrong side of an audit or penalty.
You Receive A Delayed Payout
Some beneficiaries leave life insurance proceeds on deposit with the insurance company. They draw periodic payments from the balance. This type of arrangement also earns interest and that interest is taxable. For example, you might elect to receive $3,000 a month. The portion of that $3,000 that represents interest earned must be reported on your tax return.
You can calculate the taxable portion by dividing the total amount on deposit with the insurance company by the number of installment payments youre to receive. The result is how much of your installment payment is tax-free. Any amount above that figure is considered taxable.
The insurance company should issue you a tax Form 1099-INT at years end, reporting exactly how much of your payments represent interest. The IRS will receive a copy, too.
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Ways To Avoid Taxes On Payouts
So, you have heard about a few situations that might cause taxes to be paid on the money received from an insurer. So, what can you do to avoid these situations and keep your tax liability at zero? Here are three ways that you can avoid paying taxes and keep the correct answer to the question, Is life insurance taxed?
Transfer Of Policy Is Partially Taxable
If you pay cash or other compensation to have a policy transferred to you , youll likely have to pay federal income tax on the portion of the policy value that exceeds the amount you pay for the transfer . For example, if youve paid $5,000 to take possession of a policy with a $45,000 death benefit, and didnt pay any premiums or other qualifying amounts, youll probably have to pay tax on $40,000.
Whats the difference between term life and whole life insurance?
Term life and whole life vary in many ways. A major difference is that term insurance provides coverage for a set amount of time. If you die during the term, the policy pays a death benefit. Whole life is for your entire lifetime and pays whenever you die.
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You Earn Interest Income
Interest income almost never goes untaxed, and life insurance payouts are no exception. A life insurance company might pay you interest for a few different reasons. Perhaps the death benefit is not immediately payable, rather it is payable at a later date with accrued interest. Perhaps the benefit is paid as an annuity over time with interest accruing during the period based on the current interest rates. Either way, you will likely owe taxes on the interest that is earned. While the base amount will still pass tax-free, you will have to claim the interest payments and pay taxes on those appropriately.
When You Accelerate Your Death Benefit
If youre up against a wall because you become chronically or terminally ill, you may have the option to accelerate your death benefit. Essentially, youd be considered your own beneficiary, and youd receive your death benefit early. You only want to choose this path if you know your loved ones are going to be taken care of some other way. After all, theyre the reason you got life insurance in the first place.
It may sound a bit morbid, but the one stipulation is that your request must come within two years of your death. The amount received is normally not taxed because it follows the same beneficiary rulesalmost as if youre a normal beneficiary of your own life insurance policy.
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Stay Aware Of Life Insurance Tax Implications
With life insurance playing an important role in estate planning and financially protecting your family for the future, you don’t want your loved ones to get hit by a surprise tax bill down the road. Knowing how life insurance taxes work is key in helping your family keep as much of their life insurance proceeds as possible.Though most of the time life insurance benefits are not taxed, you should always be aware of how your policy works and how changes in tax law might affect your policy. When in doubt, contact a tax professional to ensure you are on the right track.
*As long as required premium payments are timely made.
All Learning Center articles are general summaries that can be used when considering your financial future at various life stages. The information presented is for educational purposes and is meant to supplement other information specific to your situation. It is not intended as investment advice and does not necessarily represent the opinion of Protective Life or its subsidiaries.
Learning Center articles may describe services and financial products not offered by Protective Life or its subsidiaries. Descriptions of financial products contained in Learning Center articles are not intended to represent those offered by Protective Life or its subsidiaries.
Companies and organizations linked from Learning Center articles have no affiliation with Protective Life or its subsidiaries.
When Do I Pay Tax On Life Insurance
Tax can be payable on the full or partial surrender of permanent life insurance that has a cash value, says Wouters. You might also have to pay taxes if you borrow directly from the life insurance policy, and the amount that you borrow exceeds a certain amount called the adjusted cost basis of the policy. The longer you own a policy, the higher the cash value will be and, over time, the lower the adjusted cost basis will be. The excess of the cash value over the adjusted cost basis is taxable when borrowed or withdrawn from the policy.
Wouters adds that the life insurance illustration you used to help with your buying decision, as well as a calculation from the insurance company, can tell you if the amount you withdraw or borrow at any time is subject to tax. If it is, then the insurance company will issue a T5, showing how much you need to report.
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Putting Your Life Insurance In Trust
Another option is to put your life insurance ‘in trust’ this is a legal arrangement that lets you leave assets to friends, family or whoever you choose to be your beneficiary, and will not be considered part of your estate so it won’t be subject to tax on the value of your life insurance.
We have put together a helpful article with further information on putting life insurance in trust detailing the ways you can benefit from taking this popular option.
How Your Family Can Benefit From Tax
Most of the time your death benefit will be non-taxable which means your beneficiaries can gain the full value of your death benefit. Taxes can be frustrating since they take away some of the money your family is entitled to. The entire amount of a life insurance policy when paid out should be tax-free. Although, this may not be the case based on other investments where the beneficiaries would be expected to pay taxes or be taxed on the estate.
Overall, life insurance can help support your familys living expenses. The money can help them maintain their quality of life and not have to worry about making ends meet. Especially if you are the financial breadwinner, consider how your loss of income would affect your family.
The death benefit can help your family cover the costs of your funeral. Funerals can get incredibly expensive, dont let your family foot the bill. In Canada, the cost of a funeral can range from $5,000 to over $15,000.
The death benefit can also help your family pay off any outstanding debt. Tie up your financial loose ends, so your family wont have to bear the burden.
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Payouts From A Large Estate
In some cases, a life insurance payout does not go to a named beneficiary and instead goes to the insured individual’s estate. If your life insurance payout becomes part of an estate, it may be subject to estate taxes. This only impacts those with a very large estate. If your life insurance payout goes to an estate worth more than $10 million, it may be taxed.
Will I Pay Tax On A Critical Illness Cover Pay
The value on a valid critical illness claim will not form part of the estate, unless you are diagnosed with or undergo a medical procedure for one of the specified critical illnesses we cover, and you survive 14 days from diagnosis, then the policy may pay out after you die. In which case, the amount of cover will be payable to your estate and may be subject to Inheritance Tax, above £325,000. The same is true for a valid terminal illness claim.
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When You Make A Partial Withdrawal From The Cash Value Of Permanent Insurance
While youre still living, you can make a partial withdrawal from the cash value portion of your policy, and this amount is not taxable. Now, if you dont pay it back before your death, that amount will be subtracted from the death benefit before your beneficiaries receive a dime. In a way, youre cannibalizing your life insurance by eating away at the provision youve established for your family.
Why Does Imputed Income Matter
Imputed income is important to recognize since it is a fringe benefit. These are benefits such as services, goods or experiences provided by an employer that are in addition to your regular income. In the case of group-term life insurance, the IRS states that life insurance premiums for a policy of more than $50,000 are a fringe benefit and create a taxable income for the employee.
As an employer, imputed income life insurance is important to note since this information must be included in your employees’ W-2 tax forms. If it is not reported, then you will be undervaluing the amount of taxes your employees must pay.
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Cashing Out Permanent Life Insurance
In some cases, you can take distributions from your life insurance before you die.
Typically, you can only take pre-death distributions from permanent life insurance policies, and you must report some of the distribution as a capital gain. To calculate capital gains, you start with the proceeds of distribution and then subtract the Adjusted Cost Base of the asset. In most cases, the ACB is the amount you paid for the asset.
Many people erroneously assume the ACB in this case is the amount you have paid for your premiums over the years. Some of your premiums are an expense directly related to the privilege of having life insurance, and as a result, they cannot be used to calculate your ACB. Instead, you need to take the amount of premiums paid minus the value of insurance to determine your ACB.
For example, imagine you have taken a $150,000 distribution from your whole life policy, and over the years, you have paid $50,000 in premiums. According to the T5 slip issued by your insurance company, $10,000 of your premiums were simply related to the cost of being insured. As a result, you subtract $10,000 from $50,000 to find your ACB of $40,000. Subtract this amount from your distribution of $150,000 to arrive at your capital gain of $140,000.
References & Resources
Life Insurance Tax Types
There are certain instances when your life insurance payout is taxable. To protect your policy, below is a list of different life insurance tax types:
- Estate Tax: An estate tax is a tax on your right to transfer property upon your death. Your life insurance proceeds may be taxable if your estate is worth more than the maximum threshold allowed.
- Inheritance Tax: The inheritance tax is a tax placed upon the recipient for any inherited cash payouts, properties, and other assets. Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are currently the only states that enforce this tax.
- Income tax: An income tax is collected by the government for any money earned by citizens throughout the year. Typically, life insurance proceeds are not considered taxable income.
- Generation-Skipping Tax: Similarly to the estate tax, the generation-skipping tax is imposed on any assets that skip a generation. They are only enforced when they exceed the same threshold.
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Use The Policy As Collateral With A Third
Another way clients can get cash is to approach a bank or credit union.
Like before, the life insurance policy is assigned as collateral to secure a line of credit or a loanbut the lender is external.
While there is no taxable income, clients still have to pay interest, which can be higher than typical bank loansthe rate depends on the lender. And clients must get approved, so lenders will assess creditworthiness, as well as the collateral.
Schochet adds that, with WL, the bank loan generally cannot exceed 90% of the cash value with UL, its 75% if its in guaranteed investments like GICs .
Cash Surrender Is Partially Taxable
When you surrender a policy for cash, you may have to pay tax on any proceeds that exceed the cost of the policy. This usually includes the total amount in premiums that you paid for the policy, minus any rebates, dividends, unrepaid loans or refunded premiums that arent otherwise included in the income you report to the IRS.
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Are Life Insurance Payouts Included In Your Estate
Aside from the situation described above, life insurance death benefits are potentially subject to taxation in two more situations:
For the first scenario, most people opt to name individuals as beneficiaries. Doing so avoids having the payout go to an estate. For the second, having a different person or entity such as a Life Insurance Trust own the policy can keep it out of the deceaseds estate.