When your life insurance policy is paid out, it’s taxed, not just by you but also by the government. What many people don’t realize is that this isn’t always a bad thing and you should be able to take advantage of this on occasion to pad your wallet or even save for retirement.
Here are three things about life insurance that you may not know about.
- You may be able to defer the income tax you have to pay on your life insurance payout. If your policy has a term of years, or if you chose to keep it as cash value, your life insurance payout is taxed as ordinary income at the time it is received. However, if you chose a decreasing paid-up insurance policy while still living, then the taxes are deferred until such time as you elect to receive an annuity or withdraw funds in a lump sum. If you choose to withdraw funds in a lump sum, then your tax burden will be as follows:
- (a) Federal income taxes will be calculated based on the amount of the proceeds received, less any death benefit exclusion allowed for that year, plus any life insurance proceeds already received and taxed. The amount after taxes is either included in income or sheltered from taxes depending on your circumstances.
- (b) State and local income taxes vary from state to state, but the rules governing federal income taxes apply here as well.
- When your policy is paid out, it may be taxed again. Each state has its own rules for how much of a major life event is considered to be taxable, but in many cases a death payout will be considered taxable income. Since this can happen multiple times over the course of your lifetime, it’s important to know where you stand with your local tax authority.
- The value of your life insurance payout varies depending on what state you reside in.
Do you pay taxes on life insurance cash out?
The cash out on life insurance is taxable. If you’re wondering whether you’ll owe taxes on your death benefit, the answer generally depends on two factors:
1) Whether it’s a lump sum or annuity; and
2) The type of policy.
The rate at which these benefits are taxed is generally governed by what type of policy it is. You can get more details below, but the short answer is that if you’re cashing out a savings plan (e.g. whole life) or a term policy (e.g. term life), then the benefits are taxed at ordinary income tax rates, which means that you’ll pay up to 30% of your death benefit in taxes. However, if you cash out a guaranteed universal life policy or variable universal policies, then you will generally be eligible for favorable capital gains tax rates – 15% or 20%. You can generally find out what type of policy it is by asking for the policy’s Summary Plan Description (SPD). You can access it by going to the insurance company’s website and clicking on “Investor Relations”, and then “Regulatory Filings” – or simply contact them directly.
If you’re cashing out a life policy that is owned by your employer (e.g. corporate-owned life insurance), then you generally won’t have to pay taxes, but if the policy was a personal policy (e.g. owned by you or your spouse), then you’ll probably have to pay taxes on it. You may also need to adjust your tax withholding to reflect this fact.
The general rule, however, is that all cash benefits from life insurance policies are taxable at ordinary income tax rates.
If you have any questions pertaining to this article, I would be happy to answer them, and please post comments if you have any questions.