They say that only two things in life are certain – death and taxes. Thankfully, when you’re applying for life insurance, you can be reasonably sure that you’ll get around any taxes on the policy’s payout.
Typically, life insurance payouts are not taxed. For most families looking to protect themselves with $500,000 in coverage, taxes on the payout of a policy should be the last thing on their mind. Unless your policy falls into a few very specific situations, your beneficiaries will receive the full payout as a lump sum without any deductions or charges (including taxes).
When Income Tax Affects a Life Insurance Payout
Life insurance proceeds are almost never taxed, but there are a few cases in which owners of permanent insurance policies will see Uncle Sam take a little bit of money off the top. These mostly have to do with surrendering the policy while the insured is still alive, the policy lapsing, or when the person being insured takes out a loan against the policy.
Delayed Payout Interest
Instead of taking the Death Benefit of a life insurance policy all at once as a lump sum, it’s also possible to receive the policy’s payout in regular installments. While the policy is being paid out, the carrier is making money for the beneficiary by holding on to the remainder – similarly to how a bank account gains interest.
The interest that the carrier earns with your payout will also be going to your beneficiaries as part of the regular payments, but the percentage of each payout check that comes from interest is subject to income tax. You’ll still be giving your beneficiaries extra money in the long run, just not quite the full interest amount.
Profit from Surrendering a Policy with Accumulated Interest
Permanent life insurance policies don’t work the same as term policies – they’re able to build cash value over time as the policy’s owner makes payments. If the policy has built up cash value greater than its accumulated premiums, and is then surrendered, any gains over and above the normal premium payments will be taxed as ordinary income.
Ownership and Beneficiary Mistakes
If a policy is owned by one person, covering a second person, and with the payout going to a third person, the death proceeds will be considered a gift to that beneficiary and may be subject to gift taxes.
For example, under the tax code, if a wife owns policy on her husband, but lists their children as the policy’s beneficiaries, then the death proceeds of the policy will treated as gift from the mother to the children when the father dies.
Modified Endowment Contracts
Beginning in the early 80s, certain types of life insurance policies called single-premium policies came into fashion after an overhaul of the tax code in 1986 eliminated many tax shelters that were in vogue at the time.
Basically, you paid a high premium up front in a lump sum and got a certain amount of guaranteed life insurance – it was kind of like a whole life policy that only had to be paid for once.
The issue was that you could also continue pumping money into these plans, which increased the duration and payout of the policy. You were also able to borrow money against the value of the policy as a loan. This allowed people to dump millions into life insurance policies that essentially acted like overblown, tax-free, private bank accounts.
In order to close the loophole that single-premium policies presented, congress passed legislation turning any policy that didn’t pass certain tests to be a “Modified Endowment Contract,” or MEC. This rule was called the 7-pay test
The 7-pay test basically places a cap on the amount of money you can put into a policy for the first seven years of its duration – pump in more money than the cap allows, and your policy becomes an MEC, which is subject to both normal income taxes and an additional tax penalty whenever loans are taken out on the policy before age 59 ½. However, the death benefit portion of the policy still isn’t taxed, even if it becomes an MEC.
How the Estate Tax Affects a Life Insurance Payout