Usually, the money received by the beneficiary of a life insurance policy is not considered taxable. But in some cases, the beneficiary has to pay taxes. If a policyholder chooses not to pay the beneficiary immediately after his death, but to keep it in the hold of the insurance company for a specific period. In this case, that interest money will become taxable.
What Is Life Insurance?
Before becoming a policyholder, it is necessary to thoroughly know the details about the insurance, including the question that what is life insurance, for taking the best benefits from this insurance.
Life insurance is a legal agreement between an agent from a life insurance company called as insurer and the person who wants to be a policyholder.
In this contract, the insurer provides the policyholder with the utmost guarantee to pay the death benefit in form of money to the beneficiary or beneficiaries, in case of death of the policyholder. Premiums that are paid by the policyholder are lately paid to the nominated beneficiary in the form of the death benefit.
Life insurance is a contract between insurer and insured. Insured pays monthly or annual premiums and death benefit is received by beneficiary, nominated by policyholder.
How does life insurance work?
Life insurance is an agreement and to ensure its enforcement, the life insurance policy should completely explain the health condition and future risks expected to the insured person. Before signing a contract, a person must completely understand how does life insurance work.
One of the basic conditions that must be mentioned and explained in the life insurance policy is that the insured person should make the payment of at least one premium in advance and then pay further premiums regularly.
In case of the death of a policyholder, nominated beneficiaries receive the documented worth that is called as a death benefit. How good a life insurance policy is, it depends upon the credibility and financial state of the life insurance company from which it is bought.
There are several different types of life insurance policies.
What is term life insurance?
Life insurance can further be divided into several types. A person interested in life insurance must understand that what is term life insurance.
Term life insurance (pure life insurance), is a kind of insurance in which there is guaranteed payment in case of the death of a policyholder within a certain period of life.
If that specific term gets expired, the insured person must renew it for the next term, change the type of policy, from term insurance to permanent life insurance policy, or cancel it.
What is permanent life insurance?
Permanent life insurance is a vast term that includes all the life insurance policies that are not expired. In contrast to term life insurance, permanent life insurance policy remains applicable until the death of the insured person or he stops the payments or wants to cancel it. Normally,
It is a combination of both the saving portion of the insured person and the death benefit.
Permanent life insurance can further be divided into two main types, one is whole life insurance and the other is the universal life insurance. Here the question arises that what is universal life insurance and how is it different from whole life insurance.
What is whole life insurance?
Whole life insurance is a subtype of permanent life insurance that covers not only the lifetime of the policyholder but also the savings can grow at the rate documented in the policy.
What is universal life insurance?
Being a type of permanent life policies, universal life insurance also includes the cash value or saving, and death benefit. When the insured person dies, the death benefit is paid to the beneficiaries. This type of life insurance was originally initiated in the united states. Details about how does universal life insurance work, have not been discussed here.
Although, it’s the same as permanent life insurance, yet, it contains a different kind of premium structures, and benefits are based on market conditions.
Life insurance policy is either permanent or term life insurance. Permanent life insurance does not offer cash-value plan as permanent life insurance does.
What kind of people should buy life insurance?
Life is so unreliable, it doesn’t matter if a person is staying at home or on road, death angel can reach him without specification of time and place. Fear of death becomes ridiculously high when a person has some dependents that may suffer in case of is death. If he is a life insurance policyholder, he will be able to financially support his dependents in the form of the death benefit.
People lying in the following categories should buy a life insurance policy:
Parents, that have small kids that are not able to earn the living, can have benefited from a life insurance policy in case of the death of either a single parent or both.
All the parents who have handicapped children, requiring full life financial support, they can take much benefit from the life insurance policies to ensure the fulfillment of children’s needs in case of their death.
In special circumstances, where the death of one person will result in the condition that the second one will not be able to pay the loans or taxes, life insurance is the best way to be on the safe side.
No doubt, parents are real caregivers, but it does not mean that “care” is just a synonym to the word “parents”. Sometimes, children also sacrifice their time, money, or in some cases their whole life for their parents. In this case, parents may want to give their death benefits to their grownups. So, they can buy life insurance.
An adult who is more than 20, and still unmarried with no kids, he can also buy a policy if he has a plan to get married and have kids in the future.
Minimal life insurance policies can help in the burial and funeral of a person whose family can’t afford it.
Parents having small or handicapped children, people wishing to provide financial security to their grown ups or a person whose family will be unable to bear his expenses of funeral and burial can take best benefit from life insurance policies.
Are taxes applied to life insurance policy?
Before buying life insurance, it’s necessary to consider all the risks and benefits associated with it. One of the important things that a person is highly concerned about is the confusion that are life insurance proceeds taxable or not?
The Internal Revenue Service (IRS) is a service that applies various kinds of taxes on different policy plans. Generally, if an insured person dies and the beneficiaries receive the money in form of the death benefit, there are no taxes applicable to that amount of money. But there are some exceptional conditions where the taxes are applicable.
In what conditions life insurance becomes taxable?
In the case, where the policyholder has signed a contract to do not hand over the money to beneficiaries immediately after his death, instead, the company should hold it for a certain period, the death benefit becomes taxable. The reason for its being taxable is that the money saved in the company’s account will be increased by the addition of interest to its actual amount. That specific amount of money that is earned in form of interest is usually taxable as per the rules of the IRS.
If the policyholder has arranged for the insurance company to hold the policy for a few months before transferring it to the beneficiary, then the interest earned in that interim period would usually be taxable.
1. Income earned in form of interest
The interest income is taxable when it reaches a specific point. Taxes apply to the specific amount of money and it doesn’t matter either this money is a death benefit of an insured person or any other type. If it reaches a predetermined amount, it will become taxable.
So, it is inferred from the above statement that when a policyholder dies and money in form of death benefit is not transferred to the beneficiary immediately after the death, rather the beneficiary receives it after a certain period. Until that time, interest has been accumulated and taxes apply to that interest money. Tax can’t be applied to total benefit, but the interest-only.
For example, if the total amount of death benefit is $10,0000 and earned interest during a specific time, before payment, is 10% of the total amount, that 10% will be taxable.
2. Estate and Inheritance Taxes
A wrong decision taken by most investors while buying the life insurance policy is that they nominate the “payable to my estate” as the beneficiary during the contract. It may include the account of Internal revenue authority (IRA), an annuity, or the policy.
When an estate is declared as the beneficiary of policyholder, then it takes away the possibility of naming a real person as a beneficiary. This is known as estate inheritance tax. When the things are left to the estate after death, the value of the estate is also increased and the successors would have to pay extremely high estate taxes.
3. Taxes on life insurance premium
In most situations, the premiums of the life insurance policy are tax-free. It means there are no sales taxes applicable to the premiums. Moreover, they are not even tax-deductible. Taxes that are applied in case of property, vehicle, or other items purchase, are not implemented while buying insurance policies.
In other words, the premium that is paid by a policyholder is considered as the amount that a policyholder pays and no extra amount is provided to pay the taxes. However, sometimes, in some specific situations, the policyholder has to pay tax on the premiums of the insurance policy.
4. Employer-Paid Life Insurance
- When a company issues life insurance for the employee in the form of a compensation package in addition to the stipend, health insurance, and pensions, that money is considered as the income of the employee by the internal revenue agency, so the employee has to pay the tax over that amount
- However, it depends upon the amount that has been provided by the employer, either its enough to be taxable or not. If it’s not exceeding the limit of $50,000, it is not taxable. Oppositely, if the amount is exceeding $50,000, for example, if it is $90,000 or more, some of its parts will be taxable.
5. Prepaid Life Insurance
Sometimes, it’s difficult for a policyholder to pay the insurance premiums regularly due to some financial or personal reasons. Instead, he wants to pay a big amount at once. So, some life insurance policies offer the solution to this problem by allowing the policyholder to make a single payment of a handsome amount in advance.
That money is implemented to the policy’s premiums during the whole period of the policy. The lump-sum payment also increases with time because of the interest. That grown amount of lump sum money is taken as the income by the Internal revenue service. So, when there is the withdrawal of that earned money, it will be considered as taxable.
6. Cash Value Plans
Several life insurance policies serve as a dual benefit for the policyholder, for offering them cash value plans in addition to the fixed amount of death benefit. Policyholder when makes the payments for insurance premiums, some of the parts of that payment is submitted to a fund for the production of interest.
When the policies have been enforced for multiple years, the cash value originally submitted by the policyholder exceeds the numbers of premiums paid by the insurer. As this accumulated interest is considered as the profit or income of the insurer, it automatically becomes taxable money and the policyholder has to pay income tax over it.
These kinds of policies are much more beneficial for the people who not only want to provide a death benefit to their loved ones but also make investments in form of cash value plans.
Usually, life insurance is not taxable except some special circumstances. Interest money, employer-paid premiums, prepaid life insurance are the main conditions where taxable are applicable.
Tax implications to a whole life insurance policy
To avoid the confusion between different kinds of life insurance policies, it has been clarified at the start of this article that what is term life insurance and what is a whole life insurance.
In the case of whole life insurance policy, there is a major relief for all policyholders that they don’t have to pay the taxes each year over the income of their cash value plans. No doubt that money is also considered as income, but taxes are not applied by the IRS until the money is cashed out.
If a policyholder decides to withdraw the cash value of his whole life insurance plan, the amount paid by the policyholder is deducted from the total amount he is cashing out as cash value. The remaining amount will be considered taxable.
For example, if an insured person has been paying $50 each month for 5 years, it means he has paid $3,000 and the amount that has been cashed out is $3500, then the extra $500 will be subjected to the tax.
Frequently asked questions
There are some additional questions that are mostly asked by people regarding life insurance policies. Some of them have been answered below:
1. Can the IRS take your life insurance money?
Generally, life insurance is not taxable. In some cases, it turns out to be taxable. If taxes are not paid or the policyholder is unable to make payments and in case of annuity contract, the IRS and government can take the life insurance money.
2. Do you pay taxes when cashing in a life insurance policy?
In case of whole life insurance, cash value is the money that is accessible by the policyholder by the ways of taking loan over it or terminating the policy. Total amount of money, that is present in cash value account is tax-free. But in case of withdrawal, the amount paid by policyholder is deducted from total amount and the remaining amount is taxable as it is the accumulated interest that is considered as income.
3. What is difference between term life and whole life insurance?
Term life insurance:
Term life insurance policy is a kind of policy which is expired after a specific term documented in the contract according to the recommendations of the policyholder. When it gets expired, it is either renewed or terminated by the insurer.
Whole life insurance:
It is also a subtype of permanent life insurance which not only provides the death benefit of policyholder but also acts as investment during the lifetime of policyholder as long as he is paying the premiums.
4. Is life insurance a taxable benefit in Canada?
If the life insurance is paid by employer on the behalf of employee, as a part of compensation plan by company additional to the health insurance or pensions, it is usually considered as the income of employee and is taxable. Yet, there is a specific amount that can be considered as taxable, and if the employer-paid premium is exceeding that amount, the taxes are applied. However, in Quebec (Canadian province), premiums that are paid in health insurance or even the dental insurance are also considered as taxable.
5. Are life insurance policies worth it?
Of course, life insurance policies are worth it. If you have small kids who are not able to earn their living and totally dependent on you, a life insurance policy is a best option to secure their future. Moreover, if you have disable dependents, who will remain dependent throughout their life, you can make their future safe in case of your death, by buying a life insurance policy.
If you can not invest much, you can buy a term life insurance that needs less investment and when expires after a specific term you can either terminate or renew it.
Life insurance policies are not taxable except for some special circumstances.
If the policyholder chooses not to make the immediate payment to beneficiaries, just after his death, the death benefit is held by the insurance company for the period specifies by the policyholder.
During this period, interest is accumulated over the money of death benefit. That interest is taxable if it exceeds a certain amount specified by the IRS.
If the employer makes payments for the life insurance policy of the employee, as per the company plan, that money will be considered as income of the employee and will be taxable if exceeds the worth of $50k as per the recommendations of the IRS.
Some insurance companies have a cash value plan. The insured person makes the payment of a lump sum in advance. The part of the lump sum is submitted to a fund, which increases in worth due to the interest accumulation. The amount that is extra than the paid amount will be considered taxable.