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Life Insurance Policies: What Is and Isn't Taxed

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Nov. 19 2021, Published 10:35 a.m. ET

Life insurance policies serve as financial instruments designed to minimize the financial impact of the death of the policyholder. The policy acts as a contract between the insurer and the insured. The insurance company pays a sum of money to beneficiaries when the insured dies in exchange for the premiums paid by the policyholder. However, people often wonder if they have to pay taxes on life insurance.

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There are different types of policies and you can choose one depending on your needs and preferences. For example, term life insurance lasts a certain number of years and you can take out a policy for 10, 20, or 30 years. In contrast, permanent life insurance remains active until the insured dies, surrenders the policy, or stops paying premiums.

Death benefits of life insurance are tax-free.

There could be several components to the payout from a life insurance policy and they're taxed differently. The death benefits of the insurance policy are generally free from income tax to the named beneficiaries of the insured. However, the beneficiaries might decide to take the proceeds at a later date or in installments. In the meantime, the funds will keep on generating interest. This portion of interest is liable to taxes.

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When life insurance proceeds might invite estate taxes

There are other cases where life insurance might invite taxes. In rare cases, the named beneficiary or beneficiaries might die before the policyholder does. In such cases, the proceeds from the policy become a part of the legacy or the estate of the deceased and are subject to estate or inheritance tax.

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Life insurance policy taxes under different scenarios

As a policyholder, you might decide to do a number of things with your policy. Each of these cases has a distinct tax treatment. For example, if you decide to withdraw money from the cash value of the policy, any amount above the premiums paid will be taxable. Similarly, if you surrender the policy for cash, the amount received by you over and above the premiums paid by you represent investment gains, which are taxable.

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There are a few other scenarios under which the tax scene for a life insurance policy could change including selling the policy or taking out a loan on it. If your policy has a cash value and you decide to take out a loan against it, as long as the policy is in-force, the loan amount isn't taxable. However, if the policy terminates before you have paid back the loan, it's liable to get taxed.

While it might sound strange, there's a market for existing life insurance policies. The companies involving cash value could be bought by a company specializing in buying policies. Then, it pays you the money for the policy and makes the life insurance claim when you pass away. Selling a terminally ill policy is called viatical settlements and these aren't taxed by the IRS.

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