Most people with families or dependents know a little about life insurance payouts. The proceeds can help your surviving dependents or spouse support themselves when you pass away, and can be life-altering following an emergency or tragedy. Life insurance is also a smart decision among single individuals because the policy will help your loved ones pay for the funeral expenses or any debts you left behind should something happen to you.
The last thing spouses and dependents in mourning want to think about is paying taxes on a life insurance payout, however. As a beneficiary, you have just gone through something traumatic, and you are probably not ready or expecting to think about taxes — or have these difficult events compounded by an IRS audit. This guide explains such policies, whether payouts are taxable, tips for using the funds, and how wealth management professionals can help.
How Life Insurance Policies Work
Life insurance policies are contracts between you (the policyholder) and an insurance company. In exchange for premium payments, the insurer agrees to pay a lump sum (death benefit) to your beneficiaries when you die. This is worth considering if you have loved ones who depend on your income or if you wish to aid their financial needs after your death. Your beneficiaries have the freedom to use the payout they receive on whatever they choose.
Life insurance has several policies that fall into two primary types:
1. Term Life Insurance
This is the most popular and affordable type of life insurance. It provides coverage for a specific period, and premium payments do not change throughout the policy. Typical choices include 10, 15, 20, 25, and 30 years. Your beneficiaries can claim and receive the death benefit money if you pass away before the term expires, and you can renew coverage in one-year increments or at a higher annual rate in a guaranteed renewability process.
2. Permanent Life Insurance
This type of policy provides lifelong coverage and is more expensive than term life since it usually builds cash value. Types of permanent life insurance policies include:
- Whole Life Insurance
- Universal life insurance
- Survivorship life insurance
- Burial insurance
The policy’s cash value component accumulates throughout its lifetime on a tax-deferred basis. Since it acts as the policy’s savings portion, you can borrow against the cash value or choose to make a withdrawal. If you decide to end the policy, you will get its value less surrender charges.
Are Life Insurance Policies Taxable?
You do not need to report any money you receive as a life insurance policy proceeds or declare it as gross income on your next tax return, according to the IRS. The insurance company will typically distribute the money tax-free to beneficiaries. There are some exceptions and instances where you will pay taxes on related funds, however. These include:
- Interest Income
Any income you earn as interest from a life insurance payout is taxable, and you must report it on your tax return. Such instances occur when a policyholder elects to hold a payout for a specified period instead of receiving a lump sum payout. Other times, a beneficiary may decide to forego a lump sum payment in favor of incremental payouts over time, and he or she will pay taxes on the interest that the money generates.
- Estate Tax
You must pay estate tax if a life insurance payout goes to the deceased’s estate rather than directly to you as the beneficiary. In such instances, you will need to pay estate taxes (a tax on property transferred to heirs) or inheritance taxes (which are levied in six U.S. states) if you inherit the estate.
Though the payouts are not subject to income tax, they are subject to estate or inheritance tax where applicable since they are a part of your estate.
3 Tips for Using Life Insurance Payouts
You are free to spend a life insurance payout as you wish. Some beneficiaries opt to forego a lump sum payout for fear of misusing the money, and instead prefer to receive incremental or regular payouts over time as steady income. This option comes with interest taxes.
Here are some expenditure tips for families and individuals:
- Set money aside for your kids’ education
Put some money into your kids’ college fund (a 529 college savings plan). You can withdraw these funds tax-free to pay for school expenses.
- Create an emergency fund
If you live from paycheck to paycheck, it’s a good idea to have an emergency fund to take some pressure off your back. The fund should contain at least three to six months’ worth of living expenses to cover your cost of living should you lose your job or become unable to work.
- Pay off High-Interest Debt
Use the proceeds to pay off high-interest debts such as personal loans, student loans, or credit card debt.
A wealth management professional or agency understands that financial decisions tend to carry significant responsibility. They also know the efforts and thought that go into creating and building wealth — and the implications of losing it. An excellent wealth manager not only seeks out high investment returns but endeavors to create a holistic financial plan custom-tailored to your particular situation and life goals. They can help you manage and grow the funds after you receive a life insurance payout.
At Bogart Wealth, we encourage our clients to stay informed and offer them financial planning advice. We keep a close eye on various factors that could potentially affect their life insurance payouts, retirement plans, and wealth management strategies. Contact us today to talk with an expert about your life insurance payout queries.