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Is a Life Insurance Payout Taxable?

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.

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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:

  1. 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.
  2. 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.
  3. 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.

IMPORTANT DISCLOSURE INFORMATION:
Please remember that past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Bogart Wealth, LLC [“Bogart Wealth”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Bogart Wealth. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Bogart Wealth is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Bogart Wealth’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at www.bogartwealth.com
Please Note: Bogart Wealth does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Bogart Wealth’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. 
Please Remember: If you are a Bogart Wealth client, please contact Bogart Wealth, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.  Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently.
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