Are Life Insurance Claims Taxable?
Life insurance claims generally are not taxable. However, you may find that some of your life insurance proceeds are taxable under certain circumstances. You must follow certain Internal Revenue Service (IRS) guidelines to ensure that the proceeds of your life insurance policy are not subject to income tax. If your policy is subject to tax and you don't pay it, you could face penalties and have to pay any tax due.
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Types
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Two general types of life insurance exist. Term life insurance is the most basic type of insurance; it allows you to pay premiums and receive a death benefit for a set number of years in exchange for those premiums. A cash value policy is a permanent life insurance policy that is designed to insure your life until you reach age 100. Additionally, the policy builds cash value that you can use for any purpose. Of these two types of term life insurance, cash value may be subject to income taxation.
Identification
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When you cash in your cash value life insurance policy, you must pay tax on any gains the policy made. Determine the gains by measuring the amount of money you paid in premiums versus the amount of total cash value in the policy. Any amount of money in excess of the premium payments represents a gain.
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Significance
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Any gain in your life insurance policy represents a taxable gain. The gains are taxed at ordinary income tax rates. This could potentially push you into a higher tax bracket in the year that you cash in your life insurance policy. For example, if you cashed in a policy with a cash value of $100,000, and you've paid $10,000 in premiums, you would have a gain of $90,000. The $90,000 would be taxable at ordinary income tax rates.
Misconceptions
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A common misconception is that life insurance is completely tax-free. However, this is true only if the policy does not lapse. If you surrender (cash in) the policy, the policy may be subject to tax.
Prevention/Solution
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Keep your policy in force. Pay all premium payments on time. If you miss a premium payment, you generally have 30 days to make the payment to keep the policy in force. Use whatever withdrawal options are available from the insurance company as well as policy loan provisions in lieu of cashing in the policy if you need money from your policy.
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