As long as a policy owner or beneficiary pays for a life insurance policy personally rather than through a business, and pays with after tax dollars, life insurance has traditionally enjoyed substantial income tax advantages.. Cash value grows on a tax-deferred basis, and death benefits are received income tax-free. If a life insurance policy is surrendered, the gain in the policy is subject to ordinary income rates. The gain on the policy is equal to the distribution of surrender proceeds minus the total premiums paid. It is critical to note that mistakes in setting up the policy , can erase the tax advantages of the life insurance policy distribution.
Taxation of Life Insurance Benefits Single Lump Sum Payment When the death benefit of a life insurance policy are paid out in a single distribution to the named beneficiaries of the policy in a single payment, they are generally not considered income, and are exempt from state and federal income taxes. Under the federal taxcode, the entire death benefit is generally considered part of the insured’s estate and could be subject to estate taxation if the insured owned the policy at the time of death, or if the proceeds were payable the estate itself as the beneficiary of the policy. Therefore there are significant tax ramifications inherent in both the designation of the owner at policy inception, and in the definition of the beneficiaries of the policy.
Installment Settlement Approach If the beneficiaries choose settlement options where the death benefit is paid along with interest (such as life income, fixed period, fixed amount, or joint and survivor options), then the tax status of each payment will reflect its composition. The portion of each payment representing the death benefit is generally tax-free, but the interest is taxable as income. The carrier will calculate an exclusion ratio to determine the tax-free distribution of death benefits and the portion that is taxable interest. A portion of each payment is considered death benefits until an amount equal to the original death benefit is recovered tax-free. The percentage of payment considered death benefit in each distribution is calculated based on the beneficiary’s life expectancy and other terms of the distribution contract.