As people grow older, life insurance is a topic that becomes more and more important, especially for people who have children or dependents. Life insurance is a method for helping the security of others once someone dies.
Some fast facts about life insurance includes:
- Approximately 172 million Americans own life insurance.
- 34% of Americans ages 18 to 24 report they own a life insurance policy.
- 46% of Americans ages 25 to 44 have a life insurance policy.
- 53% of Americans ages 45 to 64 have a life insurance policy.
- 57% of Americans ages 65 and older have a life insurance policy.
With so many people holding life insurance policies, you might wonder: Is life insurance taxable? Read on to find out.
What is life insurance?
Life insurance is a contract between a policyholder and an insurance company through which the policy owner agrees to pay a designated beneficiary a sum of money in exchange for a life insurance premium upon the insured’s death.
Life insurance is an insurance product meant to provide financial security to that beneficiary after the policyholder passes away to help cover expenses such as funeral costs, outstanding debts and other living expenses. The amount of life insurance a person needs will depend on several factors, including income, debt and dependents.
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What makes a strong life insurance policy?
Several factors contribute to a strong life insurance policy, including:
- Coverage amount: The policyholder should choose an adequate amount for their loved ones’ financial needs. When deciding upon coverage, the policyholder should consider the cost of living, funeral costs, outstanding debts and future expenses like college tuition.
- Policy type: A policy should always meet the insured person’s needs. For example, if they want affordable coverage for a specific period, term life insurance may be a good option. If they are looking for a long-term investment, whole life or universal life insurance may be a better fit.
- Premium payments: The policy’s premium payments should always be affordable and within the policyholder’s budget. It’s essential to review the policy terms and conditions to understand the premium payments and any potential increases or decreases in the future.
- Death benefit: The policyholder should choose a life insurance death benefit that is adequate to meet their loved ones’ financial needs. The death benefit distribution should be consistent with the policyholder’s wishes, whether through an accelerated death benefit or other suitable means.
- Policy riders: Policyholders should consider adding riders to their policy, such as a living benefit rider or a conversion option, to provide additional protection and flexibility.
- Insurance company: Always choose a reputable and financially stable insurance company with a history of paying claims.
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What types of life insurance are there?
There are several types of life insuranceso before choosing one, one must understand what each entails and the positives and negatives of each.
Term life insurance
Term life insurance covers a specific term ranging from ten to thirty years.
With a term life insurance policy, the policyholder pays a premium to the insurance company. If the policyholder dies within the policy’s term, the death benefit is paid to the designated beneficiary.
If the policyholder does not die within the term, the policy will expire and the premium payments will not be refunded.
- Pros: Term life insurance is typically the most affordable form, making it accessible to many people. It also provides a straightforward and easy-to-understand way to provide financial protection to loved ones in the event of the policyholder’s death.
- Con: If the policyholder does not die within the policy’s terms, the policy will simply expire and the premium payments will not be refunded. This can make term life insurance less appealing to those looking for a long-term investment component.
Whole life insurance
Whole life insurance provides coverage for the policyholder’s entire lifetime as long as the premium gets paid. With this type of life insurance, the policyholder pays a premium to the insurance company, and the policy builds up a cash value component over time.
In the event of the policyholder’s death, the death benefit gets paid to the designated beneficiary. The policyholder can access the cash value component during their lifetime through loans or withdrawals.
- Pros: Whole life insurance provides lifelong coverage and a savings component, making it a good option for those looking for a long-term investment. You can also use the cash value component to help cover premium payments or other expenses.
- Con: Whole life insurance is typically more expensive than term life insurance, and the premium payments are often higher. The returns on the cash value component may also be lower than what could be achieved through other investment options.
Universal life insurance
Universal life insurance provides a death benefit and a savings component, with more flexibility in premium payments and death benefit amounts.
The policyholder pays a premium to the insurance company, and the policy builds up a cash value component over time. The death benefit gets delivered to the designated beneficiary during the policyholder’s death.
- Pros: Universal life insurance offers more flexibility in terms of premium payments and death benefit amounts, allowing the policyholder to adjust the policy as their needs change. The policy also provides a savings component that you can use to help cover premium payments or other expenses.
- Con: Universal life insurance can be complex, and there is a chance that the returns on the cash value component may be lower than what could be achieved through other investment options.
Variable life insurance
Variable life insurance provides a death benefit linked to the performance of a portfolio of investments. The policyholder pays a premium to the insurance company, and they can choose to allocate their premium payments to different investment options.
The death benefit is paid to the designated beneficiary if the policyholder dies. Still, the amount of the death benefit will depend on the performance of the investments.
- Pros: Variable life insurance allows the policyholder to potentially earn higher returns.
- Con: The policy’s cash value component is subject to market risk. The value of the investments in the portfolio can fluctuate, and if the investments perform poorly, the policyholder’s cash value and the death benefit are susceptible to a negative impact.
Do you have to pay taxes on life insurance?
Yes, certain aspects of life insurance can be taxed, but it depends on the type of life insurance policy and how it is structured. Generally, the death benefit from a life insurance policy has an exemption from income taxes for the beneficiaries.
However, there are some situations where life insurance may incur tax consequences, including:
- Cash value withdrawals: If a policyholder withdraws money from the cash value of a permanent life insurance policy, such as whole life or universal life policies, the withdrawal may get taxed as ordinary income.
- Policy loans: If a policyholder takes out a loan against the cash value of a permanent life insurance policy, the loan may be subject to standard tax implications if it exceeds the policy’s cost basis, which is the premium paid into the policy.
- Premiums: The premiums paid for a life insurance policy may be tax-deductible in certain situations, such as when the policy provides business-related life insurance coverage.
- Investment gains: If a life insurance policy has a cash value component invested in securities, such as stocks or bonds, any investment gains may be subject to capital gains tax if the policy owner makes withdrawals or loans against the policy.
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What types of taxes apply to life insurance?
Just like there are different types of life insurance, there are also different types of life insurance taxes. Keep reading to find out more.
If a policyholder withdraws money from the cash value of a permanent life insurance policy, such as a whole life or universal life policy, the withdrawal may be subject to income tax.
This means that the withdrawal is treated as regular taxable income and is subject to the same federal and state income tax rates as an individual’s salary or wages.
Related: What Is Adjusted Gross Income? Everything You Need To Know.
Capital gains tax
If a life insurance policy has a cash value component invested in securities, such as stocks or bonds, any investment gains may be subject to capital gains taxes if the policyholder makes withdrawals or loans against the policy.
Capital gains tax is a tax on a policyholder’s profit from the sale of a security. In the case of a life insurance policy, the policyholder realizes a gain when they make a withdrawal or loan from the policy that exceeds the policy’s cost basis, which is the amount of premium paid into the policy.
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If the death benefit from a life insurance policy gets paid to the policyholder’s estate, it may be subject to federal estate taxes, depending on the size of the estate and applicable federal and state estate tax laws.
The estate tax, also known as the inheritance tax, is a tax on transferring wealth from one generation to the next. It is calculated based on the policy owner’s estate value at the time of death.
Related: Why is Estate Planning More Important Now Than Ever Before?
Some states impose a tax on the premiums paid for life insurance policies, known as a premium tax. The premium tax is a percentage of the premium that states generally use to fund various insurance-related programs and services.
The amount of premium tax owed will depend on the state in which the policy is issued and the premium paid.
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Does the type of life insurance payout affect the way it is taxed?
There are two types of life insurance payments: lump sum and income stream.
A lump sum payment is the more common of the two, and with this option, the policy’s total death benefit gets paid out in one single payment immediately after the policyholder’s death.
An income stream, like an annuity life insurance policy, will provide a series of payment installments over a set period.
With a lump sum, the death benefit is generally not taxed as income to the beneficiary or beneficiaries. However, if the policy has a cash value component, such as a permanent life insurance policy, the amount of the death benefit that exceeds the policy’s cash value may be subject to income tax.
With an income stream, the payments received may get taxed as income to the beneficiary. The taxation of annuity payments depends on several factors, including the type of annuity, the policyholder’s tax bracket and their investment earnings.
Generally, annuity payments are taxed as income, which means they get taxed at the recipient’s marginal tax rate.
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What do you need to know about life insurance taxes?
If life insurance is on your mind, it can be a great benefit to leave behind once you’re gone.
While there are some financial considerations to make and some taxes to be aware of, life insurance is an asset to consider. Always consult a tax professional for the very best legal advice.
For more information on taxesthe IRS or finding the right life insurance company, visit Entrepreneur.com.