How are life insurance proceeds taxed?
A well structured life insurance policy is almost always 100% INCOME TAX FREE, but it can be complicated or taxed if:
- You have more than two parties to a life Insurnce policy - example if you have the a company as owner, the owner as the insured and the spouse of hte owner as beneficiary (three party insurance), it will be a taxable event.
- You transfer ownership of the policy via a sale, many times it can cause income tax on transfer or a taxation of the death benefit (especially if sold to an in east or - call Investor Owned Life Insurance or some similar name.
However, if you own your own life insurance policy (vs. having it be owned by a trust or other entity), it is typically included in your estate and could be subject to ESTATE TAX.
Here is a good summaries from Investopedia:
Estate Tax: http://www.investopedia.com/articles/pf/06/transferlifeinsurance.asp
Income Tax: http://www.investopedia.com/articles/personal-finance/121914/life-insurance-policies-how-payouts-work.asp
It depends, as a death benefit tax-free. If you are cashing out early the gains are taxed as ordinary income. In some cases if used properly, they can be distributed tax-free for LTC or retirement income purposes through loan provisions for permanent policies only as these are not avaiable through term policies.
With very rare exceptions, life insurance proceeds are never taxed as ordinary income. However, they will be taxable as part of an estate. However, with the current estate tax exemption at $5.43 million, most estates will never owe an estate tax at the federal level. You may have to check in whether in fact the state in which the decedent died has an estate or inheritance tax independent of the federal tax. I hope this helps and good luck.
Great news...life insurance proceeds payable to a named beneficiary (a real person) is free of federal income tax. So, 100% of the benefit is free.
However, if the life insurance death benefit is paid in installments instead of a lump sum, the interest portion (if any) is taxable. The principal is tax-free.
The insurance proceeds may be included in the taxable estate of the owner. Not to worry, though...the estate tax exclusion is over $5.3 million. So, estate taxes is a mute point for most people. Only if the net taxable estate (after certain deductions) is over $5.3 million would the family have to worry about estate taxes.
As a beneficiary, life insurance proceeds are not included in your gross income, therefore, do not need to be reported and are not taxed. Since life insurance premiums are typically paid with after-tax dollars (money that has already been taxed), their proceeds are exempt from income tax.
However, life insurance proceeds are taxed if they are paid in installments instead of a lump sum (e.g. Minnesota Life Omega Builder has an option of installments or lump sum due to their living benefit features). The interest paid on the installments is taxed at ordinary income rates.
In regards to estate taxes, the death benefit is included in the deceased's estate (the exemption is $5.45 million per individual in 2016), so it may be subject to federal and state tax if not established under an Irrevocable Life Insurance Trust (ILIT) or if gifted and three years has not passed.
If you have any further questions, I'd be happy to help.