Life insurance is designed to give you some reassurance that once you are gone the people who relied on you will be looked after. Those people are your dependents and can be your children or a partner.
These dependents will be financially safe and there are several different things to think about when taking out life insurance, that can be the type of policy you want, when you will need it and how you can buy it. Lets Learn “Is Life Insurance Taxable?”
- 1 How Does Life Insurance Work
- 2 Types Of Life Insurance
- 3 Is A Life Insurance Payout Taxable?
- 4 Final Thoughts
How Does Life Insurance Work
Life insurance will pay out in either a lump sum or smaller regular payments that are spread over a duration of time. The amount of money paid out of your life insurance depends on the level of cover you take out.
You will get to decide how the plan is paid out and what the plan will cover. You can decide that the plan will cover your mortgage payments on any property you own.
This can also apply to rent if you do not own property and do not want your dependents to have to saddle the responsibility of rent payments then you can do so.
The final option most commonly taken is for your dependents to be given an inheritance left behind by your insurance.
Types Of Life Insurance
There are two types of life insurance you can take out:
Term Life Insurance Policies
This policy runs for a fixed period of time; this is known as the ‘term’ of your policy. This fixed period of time can run from 5 years to 10 or even 25 years.
Like any life insurance policy the pay out will only begin once you have died.
Term life policies come in three kinds:
Pays out as a lump sum if you pass away within the agreed term. This is the most affordable and simple option and the level of cover remains the same throughout.
This level of cover will reduce each year. This policy is designed for paying a mortgage as the loan will decrease overtime.
This is the simplest of the three plans, the level of the cover will rise over the term of the policy. This is so the plan can keep with inflation.
Whole Of Life Insurance Policies
The second of the two types of policies is the whole of life policy. This policy will pay out no matter when you pass away. But, this policy requires you to keep up with the premium payments attached to the insurance.
This policy is mostly used to help towards a funeral or for planning around Inheritance Tax. The whole of life policy is more typically more expensive than other shorter termed policies.
The main issue with this policy is due to there being no time frame you will end up paying more into the policy than you will end up getting out when you do die.
Is A Life Insurance Payout Taxable?
The main perk of a life insurance policy is that it is considered a death benefit and is typically tax-free. Your beneficiaries of the policy will not have to report the payment as an income, this makes it a tax free lump sum that can be used freely.
However, not all types of life insurance are tax free, there are some exceptions. The payout from a life insurance policy can be taxed if:
The Payout Is In Installments
Typically life insurance payouts are in one lump sum, some people may choose to take the payment in installments better known as annuity.
In this case, the money will be held by the insurer in an interest bearing account and then will issue out a percentage of the money over a set number of years.
Whilst this provides a steady income stream for the beneficiary, the income that will accumulate over time on the death benefit will be subject to income tax.
The Death Benefit Becomes Part Of Your Estate
If the total taxable value of all your assets is greater than the amount set in the federal estate tax exemption limit, then the IRS will enforce an estate tax.
If you die with a life insurance policy then the payout will be counted in the value of your estate. This will be accounted for no matter if you have named a beneficiary or not.
The payout in your policy could push your estates taxable value over the set limit meaning your heirs would have to pay an estate tax on any of your assets above the threshold, there is also a nine month deadline on these tax payments.
If before you die you make a will or have a trust in place, then the life insurance payout can be used to pay the estate taxes, this will only be the case if you name your estate as your beneficiary.
But if you choose one or more beneficiaries, they will not be held liable for the estate tax, they will receive the life insurance payout tax-free and the estate tax will be paid from the other assets you own.
So, for the most part your life insurance payouts are not taxable, but some situations can still lead to taxation, particularly if you earn interest on the potential payouts or the policy owner has a high net worth.
It is crucial to understand how and when taxes can apply to you and when they will not apply to you.
The key takeaway from this article should be that life insurance payouts are usually tax free. If your policy payout causes your estates worth to exceed the IRS estate tax limit then your heirs could be charged taxes.
Finally, your beneficiaries may have to pay taxes if they choose to make the insurance plan be paid out in installments.
This will also apply if they decide to go with a third party policy owner who will let the money gain interest at the expense of having taxes paid upon the monies withdrawal.