Life insurance policies can be tricky to understand, especially when it comes to how they affect your taxes.
According to a recent study from ValuePenguin, 50% of Americans believe they can write off their auto, health, home or life insurance policies as tax deductions. Most often, however, life insurance premiums and proceeds are not tax deductible.
Still, there are a few circumstances in which life insurance policies will affect the taxes of the policyholders or beneficiaries. It’s important to understand what these circumstances are in order to choose the best whole or term life insurance policies for your needs.
Is Life Insurance Taxable?
Life insurance premiums are considered personal expenses by the Internal Revenue Service, so they are usually not tax deductible. That means policyholders can’t write off their monthly life insurance payments on their taxes.
However, life insurance proceeds are also not taxed as income in most cases. That means beneficiaries can collect the insurance payout in its full amount without paying taxes on them, as they would with income.
When is Life Insurance Subject to Taxes?
Despite the general rules above, there are a handful of circumstances in which life insurance proceeds will be subject to taxes.
If life insurance proceeds are paid to the beneficiary in installments — instead of as a lump sum — any interest accrued on the proceeds over time will be taxable.
If the proceeds go to an estate instead of an individual, they may be taxable. Specifically, if the estate’s value exceeds $11.7 million after the proceeds come through, an estate tax must be paid.
The life insurance policyholder may choose to take out cash or a loan from their own policy. Some of the money withdrawn — usually any interest or investment gains accrued — will be subject to taxes. If the premiums increase as a result of the withdrawal, the policy may be deemed a modified endowment contract (MEC), which is also subject to its own tax rules.
If the policyholder decides to terminate their account, they will receive the cash value of their policy. They will also, however, have to pay a surrender charge and be taxed for any investment gains on that cash value.