subject: Life Insurance Tax Treatment [print this page] Life Insurance Tax Treatment
No matter what you do, you can't get away from having to pay taxes. This even includes the payout from a life insurance policy. There are a few different ways that the proceeds from a life insurance policy are paid out and each has an accompanying tax situation that must be handled. The policy itself has tax benefits and consequences. Although the premiums paid to a life insurance policy are paid with after tax funds, the premiums cannot be claimed on your taxes. However, interest earned on the cash benefit of a particular insurance is tax deferred until the death benefit is paid out or the money in the policy is otherwise withdrawn.
Generally, money from the policy that paid to the beneficiary because the policyholder died is not subject to federal taxes. However, the cash given may be subject to estate taxes as part of the estate you are leaving behind to your heirs. So even though the amount of money left to your heirs may be well under the allowed non-taxable amount, if the amount of the policy pushes it over them limit then your heirs will have to pay estate taxes on everything. For example, if your estate is $500,000 but the insurance policy is $300,000 to the IRS the total estate value is $800,000 and subject to taxation.
If the life insurance policy pays dividends, the amount of the dividends paid out can be taxed if it exceeds the amount the policy costs. Only in special circumstances does this ever happen and so most people do not have to worry about this. However, if you are paid interest on your dividends then you will be subject to taxation on the dividend amount. Generally, this happens if you reinvest the money you receive into another financial vehicle such as a CD, bonds, or a savings account.
Life insurance policies can be surrendered if they have a cash value. As long as the cash value is less than or equal to the amount you paid into the policy, you can claim that money tax free. This is because, as noted before, you've already paid taxes on that money. However, if your cash benefit earns interest and you are given an amount that is more than what you have paid, then you are subject to taxation on the excess amount. When investing in life insurance, it is best to seek the advice of a knowledgeable tax attorney or CPA.
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