If the insured dies while a life insurance policy is still in force, the proceeds may be taxable. The exceptions to this rule include dividends and interest withdrawn from life-insurance policies. This article discusses the other types of life insurance policies that are taxable. If you own any of these kinds of insurance policies, you should know their tax treatment. To help you decide whether to make a withdrawal, consider these scenarios.
Death Benefits Accessed Before the Insured
When death occurs before an insurance policy is fully paid out, the surviving beneficiaries must make the necessary arrangements to access the money. For example, a non-working retiree may be able to continue health, dental, and vision insurance coverage from their last employer. Depending on the employer's contract, they may receive the death benefits without tax. Nevertheless, any surviving family member may want to access the money for ongoing expenses such as mortgage payments or credit card payments.
Generally, the death benefits from an insurance policy are tax-free to the beneficiaries. However, the insurance company may choose to hold on to the proceeds after the insured passes away and make periodic payments to the beneficiaries. In such a case, the beneficiary may receive both principal and interest, or only the interest portion. The former is tax-free, while the latter is taxable as ordinary income. A person should make sure to understand the tax implications before making such a choice.
If the insured passes away before the death benefit can be received, the death benefit is tax-free. Typically, terminally ill patients to use the death benefit to pay for expensive medical care. In this case, the beneficiaries don't pay taxes on the death benefit lump sum. However, death benefits accessed before the insured pass away can still accrue interest. Unlike the death benefits that are tax-free, living benefits must continue to be paid in premiums.
It is essential to understand how death benefits are taxed and how to maximize their value. For example, if a child becomes the beneficiary of a parent's life insurance policy, the proceeds can be subject to gift tax. A child who is the beneficiary of a parent's life insurance policy may be taxable because the parent is a donor. It is also crucial to note that if the insurance policy is owned by a third party, the beneficiary's estate must file a tax return for the amount it paid in taxes.
A life insurance policy can provide a death benefit of several million dollars. Even if the insured passes away, the amount of the death benefit may be surprising. Taking advantage of the gifting opportunities and transferring ownership of the policy can help avoid estate taxes. This way, the proceeds from the death benefit will pass free of gift tax and avoid the taxable estate. The tax savings can be substantial! Therefore, it is advisable to seek professional advice when transferring ownership of life insurance.
Some insurance companies offer accelerated death benefit riders. By opting for these, the insured can access a portion of his or her death benefit while he or she is still alive. This can help them pay for expenses related to terminal illness. It will also minimize the amount of inheritance the beneficiary receives. These riders will usually reduce the beneficiary's inheritance. Therefore, accelerated death benefit riders may be beneficial.
Interest and Dividends Withdrawn from Life Insurance
When you withdraw the cash value from a life insurance policy, it's important to understand how to calculate the tax liability. As a general rule, you should not pay tax on the amount you withdraw more than the total of your premiums. However, you can take out loans from your policy without incurring tax liability. Cash value can be borrowed for many purposes. Some people use the cash value to pay insurance premiums, others use it to purchase a higher death benefit, and still others withdraw the money.
While most dividends from life insurance are tax-exempt, there are situations when you may have to pay taxes on them. If you withdraw the cash value from your policy and use it for expenses, you will have to pay tax on the money. Dividends from life insurance are considered a refund of the premiums you paid. In the case of the latter, you'll need to deduct the amount of taxes you paid.
If you want to use your cash dividends to pay premiums on another policy, the cash value of the policy should be deducted from the cost basis of the new policy. However, if you're using cash dividends to pay premiums on the policy B, you can't use the premium credit on policy A for premiums on policy B. This means that you will have to pay taxes on dividend payments from policy A.
If you're planning on transferring the proceeds of your life insurance policy, you should carefully consider the tax consequences. A death benefit may trigger a generation-skipping tax if it's inherited by another family member. This tax is only enforced in six states, but the amount is still significant. You may also have to pay inheritance tax if you inherit assets. As long as you understand the tax implications, you'll be better off with the latter option.
The amount you withdraw from your policy will depend on the type of policy you have. A Prudential policy, for example, will combine paid-up additional insurance with a One-Year Term policy. You'll never be able to put these dividends back into the policy. If you're planning to live decades after your policy ends, it's best to withdraw. Even though the cash value may increase, interest will continue to accrue on the loan you're taking out.
Another common option is to borrow from the cash value of your life insurance policy. While this option reduces your death benefit, it's still preferable to cashing out the policy. The downside is that you'll have to continue paying premiums if you take this option. However, it doesn't require surrender charges, and you'll need to pay interest on the loan. The interest you pay will not be deductible and will increase your tax liability.
Other Types of Life Insurance Policies That Are Taxable
The amount you receive when you cash out a life insurance policy is not tax-deductible. The money you receive is the difference between the policy's cost and the amount you paid in premiums. There are exceptions to this rule, such as business owners who pay into employee life insurance plans. If you have an existing life insurance policy, the proceeds are not tax-deductible. Alternatively, you may be able to cash out your policy in exchange for cash. In that case, you will likely have to pay tax on the cash value.
In most cases, death benefits are not taxed. However, if you delay cashing out the policy, your beneficiaries may face a tax bill. You may be able to avoid this situation by naming your beneficiaries as beneficiaries. This is especially important if you have a spouse or children who will be relying on you. A beneficiary who waits too long to take the benefit of the life insurance may end up with a tax bill.
Although the death benefits are usually tax-free, life insurance proceeds can be. In particular, cash-value life insurance policy owners will be subject to tax consequences. Because cash-value life insurance policies accumulate interest over time, they are tax-deferred until they are accessed. The amount that is considered taxable represents the amount over the premiums that the insured paid. This is essentially a result of the investment gains.
Whole life insurance and universal life insurance also have an investment component. The premiums paid are invested in additional funds that can grow tax-free and increase the death benefit when the insured dies. These permanent policies are complex and differ widely in their details. Talking with your insurance broker is a wise move. These policies are not for everyone. Decide carefully before you sign up for one. If you decide to invest the proceeds, make sure you understand the tax implications.