Set Money Aside For Your Children’s Education
Create a college fund for your kids by putting some money into a 529 college savings plan. The funds can be withdrawn tax-free to pay for qualified school expenses. If possible, when paying for education, use any available tax credits first. After this, consider using 529 funds on remaining expenses, while watching out for penalties. You need to withdraw 529 funds during the year they will be used for school expenses.
How To Choose A Life Insurance Policy
As with any major life decisions, choosing a life insurance policy is nothing to jump into without doing some research first. It is important for you to know what each policy offers, and the benefits and potential drawbacks associated with the different types of life insurance. Once you understand how each policy works, you can make an informed decision and decide which policy fits your specific needs. For life insurance, there are three basic types of policies that you can choose from.
No matter which policy is best for you, it is important to make sure that you are going with a reputable company with a track record of strength. Life insurance is a long prospect, potentially lasting 50 years or more. You want to make sure that you have a company that has a long track record of strength and who will be around for the long haul.
When Interest Is Received Along With The Death Benefit
You may opt to have your life insurance company hold on to the death benefit of your policy for a period of time, then distribute the death benefit to your beneficiary in installments, or at a later date. While the life insurance company is holding on to the death benefit, it will earn interest.
When they start paying installments to your beneficiary, the paid installments can either come from one of two sources:
- The principal of the death benefit .
- Solely the interest collected from the death benefit.
The principal portion of the death benefit is tax-free, but the interest is considered part of your beneficiary’s gross income and will be subjected to income tax.
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Is Life Insurance Taxable If You Cash It In
In most cases, your beneficiary won’t have to pay income taxes on the death benefit. But if you want to cash in your policy, it may be taxable. If you have a cash-value policy, withdrawing more than your basis is taxable as ordinary income. It’s best to check with your provider before you cash in – some policies state cash withdrawals made in the first 15 years are taxable.
What Happens To Life Insurance Proceeds If The Beneficiary Dies
It depends. If the policy named a contingent beneficiary, then the proceeds will go to the contingent beneficiary. This is why it is extremely important to plan for this situation and name a contingent beneficiary in addition to your primary beneficiary. If there is no contingent beneficiary, then the proceeds will likely go to your estate to be distributed according to your will or the intestate succession laws of your state. Unfortunately, if the proceeds go to your estate, then you might be left with a hefty tax bill. They might no longer pass to a beneficiary tax-free, so this situation might cost you thousands of dollars.
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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
Are Life Insurance Payments Tax Deductible
If you have an individual policy, life insurance premiums are not tax deductible. Theyâre treated the same as any other expense.
Group term life insurance policies, typically provided by an employer or association, are different. The employer can deduct life insurance premium payments for up to $50,000 of coverage per employee, so long as the employer is not the beneficiary. As an employee or association member, the cost of group or supplemental life insurance can actually be added to your taxable income.
If you have less than $50,000 of group and supplemental term life insurance, you wonât be taxed on the value of it. However, any coverage over $50,000 will be assigned a fair market value by the IRS, which is determined by your age. The amount you pay in premiums is deducted from the fair market value, and the difference is considered to be taxable income. It may seem odd to pay taxes on coverage that youâve already paid for, but this rule is meant to account for cases in which you receive a discounted rate by purchasing group life insurance. With group coverage, risk is pooled across a large number of people so, if youâre quite unhealthy or older, you may receive a much lower rate than you would get with an individual policy.
Editorial Note: The content of this article is based on the authorâs opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.
Is Group Life Insurance Taxable
Do your employee benefits include a term life insurance policy ? For the first $50,000 of coverage, the IRS excludes the group life insurance premiums your employer pays on your behalf. As long as your coverage doesn’t exceed $50,000, your premiums are not included in your taxable income and are therefore tax-free.
What if your employer provides more than $50,000 in coverage? Your employer will add the cost of the extra coverage to your reported wages, where it is subject to income tax and Social Security and Medicare taxes. Also note: The tax on excess coverage isn’t based on what your employer pays but instead on how much the IRS determines you owe. That said, this cost may be minor, especially if you’re under age 65. An additional $50,000 of coverage will add only $33 in taxed income per month if you’re age 60 to 64 and only $3 if you’re age 25 to 29. Don’t want the additional coverageor the taxable income? Ask your employer if they can reduce your coverage to $50,000.
Create An Emergency Fund
If you’re living from paycheck to paycheck, an emergency fund could take some of the pressure off. You should have between three and six months worth of living expenses in your emergency fund to cover your cost of living if you lose your job, your car breaks down or you become ill and unable to work. In creating a sufficient emergency fund, use the adage “pay yourself first.” You could agree to pay a set amount into the fund each month before any other bills are paid.
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How To Make Life Insurance Easier For Your Beneficiaries
Losing a loved one is hard, but you can make claiming your life insurance easier for your beneficiaries.
Use the checklist below to make your policy more efficient for your beneficiaries:
1. Name your beneficiaries
Properly filing the name of your beneficiary with your life insurance company can quicken the settlement process and help avoid probate, associated costs and most outstanding debts owed.
2. Inform your beneficiary
Regardless of who you choose as your life insurance beneficiary, be sure to let them know. Even more helpful? Provide them with your life insurance companyâs details.
In the event of your passing, theyâll be able to file a death claim easily without searching through your paperwork.
3. Put everything in writing
Be specific when it comes to how you want your policyâs death benefit distributed. For example, if you want your children to receive your life insurance payout, list their legal names and social security numbers rather than simply listing âchildren.â
If you wish to name a charitable organization as the beneficiary, outline the organizationâs name, address and tax ID number.
4. Outline primary versus contingent beneficiaries
There are two common types of beneficiaries:
A primary life insurance beneficiary is the individual who is first in line to receive your life insurance payout. Typical examples include your spouse, children or other close family members.
5. Provide updates when needed
How Do I Report A Payout On My Tax Return
You don’t need to report a payout on your tax return unless you receive interest earnings on the death benefit.
If a payout needs to be reported, the insurance company will issue a T5 slip.
If you surrendered your policy, this form would be issued to you it will go to your beneficiary if you pass away. Line 121 of the form will outline the interest earnings that would need to be reported.
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When There’s A Profit
Since whole life insurance can cost five to 15 times as much as term life, it’s not uncommon for a person to surrender their whole life policy, collect the cash that has accrued, and use those funds to purchase a term life insurance policy.
Do you have to pay taxes on life insurance that’s been surrendered? Yes, if the cash received is more than the premiums and fees paid into the policy. While it rarely happens, it’s good to know that it is a possibility.
Note: Never surrender or sell a policy without first having another life insurance policy in place. There should be no gaps in coverage, even if it means borrowing from savings and paying savings back once the old policy has been sold or surrendered.
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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Life Insurance Tax Changes In 2017
On January 1, 2017, the Canadian government implemented significant tax changes that impacted new life insurance policies. Perhaps the most consequential adjustment was the amendments made to the NCPI factors, such as updated mortality tables.
In general, these changes resulted in a lower NCPI, which in turn creates a higher ACB for a longer period of time. As noted previously, ACB is instrumental in determining how much can be paid out tax-free.
Types Of Taxes That Can Make Life Insurance Taxable
Because a life insurance death benefit isnât considered taxable income for most people, income tax usually doesnât apply. However, you or your beneficiary might be subject to estate taxes, inheritance taxes, gift taxes, or the generation-skipping transfer tax.
Estate tax: The federal estate tax applies to high-value estates. Any amount of your estate over the current estate tax threshold is subject to taxation.
Generation-skipping transfer tax: This applies to assets that skip a generation. It has the same exemption limits as the estate tax.
Inheritance tax: A tax levied on inherited money, property, investments, or other assets. It is only collected by six states and ranges from 10% to 20%.
Gift tax: A federal tax on assets given as gifts. The gift tax is in place to prevent people from avoiding taxes by âgiftingâ money rather than including it in an estate, like if you transfer ownership of a life insurance policy to a beneficiary while youâre still alive. There is a lifetime exemption amount, which is the same as the estate tax limit, as well as an annual exemption amount .
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Generally, life insurance is not taxable â your beneficiaries receive the entire death benefit. However, some circumstances could put the death benefit at risk of taxation. When you pass away, itâs not you who will bear responsibility for taxes on your death benefit, but your loved ones.
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When Are Life Insurance Premiums Taxable
While life insurance payouts generally arent taxable if youre the beneficiary, its possible for some group life insurance premiums to be subject to federal income tax.
If your employer gives you group term life insurance coverage of more than $50,000 as a fringe benefit, you may have to include the premiums for that coverage in your income, less any contributions you made toward the plan during the tax year. But if the life insurance death benefit is for less than $50,000, you generally dont have to include the premiums as income.
Who Can Be A Beneficiary
You can name your spouse, children, dependants, another family member, a friend or a charity as a beneficiary. If you name more than one beneficiary, the insurance company will divide the death benefit between them. You can assign percentages of the death benefit to each beneficiary, e.g. 50 per cent to your spouse, 50 per cent to your children.
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When You Profit From Surrendering Your Cash Value Policy
After buying a replacement term life policy, getting the payout from your cash value account, and then surrendering your permanent life policy, you may owe taxes. Bummer! If the amount you receive is more than what youve paid in fees and premiums over the life of the policy , youll need to report that amount as extra income. But take heartthis hardly ever happens.
Note: The order here is important. You never want to be even a moment without life insurance coverage. Dont worry if youre double-covered for a few days with both whole and term insurance. Make sure the term is in force before surrendering your whole life and receiving the cash value amount.
When You Receive An Annuity
Earlier, we mentioned that life insurance proceeds are normally given as a lump-sum payment. However, if a beneficiary prefers it, they can receive their proceeds in increments. This is known as an annuity. Some people prefer annuities because they resemble a steady stream of income and can be beneficial to retirees who no longer receive monthly payslips. And for folks who are not comfortable managing large sums of money, receiving smaller amounts on a regular basis can feel less risky.
Most life insurance policies dictate that annuities can be granted on the condition that the benefit will accrue interest over time. While you still don’t have to pay taxes for your death benefit, you will likely be taxed on the interest you accrue.
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Next Steps: Ways To Protect Life Insurance Proceeds
Life insurance is a way for you to help protect your loved ones financially after youre gone. The simplest way to help them avoid paying tax on the payout from your life insurance is to name them as beneficiaries, rather than naming your estate.
But if your financial situation is complex, or your estate may be subject to estate taxes, its probably a good idea to consult a financial adviser or tax professional who can counsel you on ways to minimize tax impact, such as an irrevocable life insurance trust. And a life insurance specialist may be able to help you understand what life insurance products are best for your specific situation.
Relevant sources:IRS: Life Insurance & Disability Insurance Proceeds | IRS Publication 525: Taxable and Nontaxable Income | IRS: Estate Tax | IRS Publication 559: Survivors, Executors and Administrators
Christina Taylor is senior manager of tax operations for Credit Karma Tax®. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is an Enrolled Agent, the current treasurer of the National Association of Computerized Tax Processors and holds a bachelors in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on .
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Name The Proper Beneficiary
The easiest thing that you can do to avoid taxes is by naming a proper beneficiary. Make sure that you choose a person as the beneficiary of your life insurance. That person can receive the proceeds as a lump sum and not owe a single penny of taxes even if the payout is quite large. You should also name a contingent beneficiary in case your original beneficiary becomes deceased before you. This ensures that your beneficiary is a real person and thus will qualify for the life insurance tax exemption.
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