Is life insurance taxable?

Is life insurance taxable? This is a question that many people ask themselves when considering purchasing a policy.

2 min read
Is life insurance taxable?
Photo by Kelli McClintock / Unsplash

Is life insurance taxable? This is a question that many people ask themselves when considering purchasing a policy. Many insurance companies will offer you a quote on a policy without asking, is life insurance taxable? If you are not familiar with insurance terms, you may not know that most policies are not classified as 'taxable' until paid out. For many, this makes the whole process seem very confusing.

Understanding what is tax-free and tax-related helps to have a basic understanding of how insurance works. The insurance company gives you cash when purchasing a term life, whole life, or universal life policy. This is called a premium. You pay into this premium monthly, making payments reported on your insurance company's statement of account. Payments you make are subject to UBIT (known as the death benefit).

If you do not make monthly premium payments and your death benefits are exhausted, you will lose all of your premiums. Life insurance proceeds usually are treated as taxable income by the Internal Revenue Service. If you withdraw from your policy before it is surrendered, you will be taxed for this withdrawal, but only if your premiums are more than the tax-free allowance. Most insurance companies provide an exemption from both UBIT and taxable income.

There are two exceptions to treating your death benefit as non-taxable income. First, if you die while a beneficiary is still alive, your death benefit will be paid directly to the beneficiary. Second, if you die due to a robbery or natural disaster, your death benefit will be transferred to a named charity. This is called a forgiven death benefit.

Some life policies pay dividends as well. The most common example of this is a term life insurance policy. A term policy is one in which premiums are paid either periodically or monthly, and the death benefit is equal to the current value of the premiums. Dividends may be taxed as ordinary income. However, the dividends are not taxable income if the death benefit is equal to or greater than the premiums paid for a non-taxable permanent insurance policy.

If you are unsure of the laws in your state regarding dividends, be sure to contact a qualified tax professional. These tax experts can give you the answer you need. Taxation of life policies is complex, and no one answer is suitable for all. Always seek the advice of a knowledgeable and qualified tax professional.