What You Need to Know About Taxes and Life Insurance

Are you a life insurance policy holder or beneficiary who often wonders about the tax implications of inheriting money or selling your life insurance policy for cash? The good news is that there are usually little or no tax consequences when you sell a policy or inherit money from one. That’s because accounting laws are set up to encourage people to purchase insurance and leave funds to their survivors. The problem is, there are a lot of myths out there about how the process works, particularly from the policy-holder side of the equation. 

Here are some of the most frequently asked questions on the topic. Note that only in one situation, and a very rare one, are you obligated to pay income tax on a policy, and even in that lone scenario, a significant portion of the total is taxed at the lower capital gains rate rather than your marginal rate. If you currently own a whole or term policy, or are the beneficiary on someone else’s, make note of the following points.

Are Your Heirs Taxed on Death Benefits They Receive?

There are some rare exceptions, but for the most part, beneficiaries get proceeds tax-free. When a lump sum payout sits in an interest-bearing account before the heir withdraws any money, then the interest is subject to taxation, but the original death benefit amount is almost never.

What Happens if You Sell a Life Insurance Policy for Cash?

There’s very good news for anyone who intends to sell a policy, for whatever reason. When you sell, the IRS categorizes the proceeds into three kinds of income: repayment of basis, capital gains, and ordinary income. The repayment of basis part is calculated simply as the amount of premiums you have paid, minus the cost of the insurance. Ordinary income and capital gains income are a bit trickier. Keep in mind that when you do sell, your insurance agent, and whoever purchases your policy, will do these calculations for you. It’s best to just look at a typical example. You can plug your own values into the example to see what your own situation might look like, but always get an official breakdown of the amounts from your own accounting professional.

Suppose you have paid $50,000 in premiums on coverage that has a cost of insurance amount of $10,000. Subtract the cost from the total pay-in to get your adjusted basis. Thus, $50,000 – $10.000 = $40,000. Next, you need to know the cash surrender value and the sale price (what you receive in cash when you sell to a third-party). Assume in this example that the cash surrender value is $58,000 and you received $61,000 upon sale to a buyer. Now we have all the pieces of the puzzle needed to make the final calculations.

The sale price minus the adjusted basis is your gain. In this case: $61,000 -$40,000 = $21,000. So, you had a $21,000 total gain on the transaction. The big question is how much of that gain is subject to taxation, and what rate will you pay? Of the total gain ($21,000) the amount that the IRS will call ordinary income is cash surrender value minus amount of premiums you paid. Thus, $58,000 – $50,000 = $8,000 is taxed at whatever your personal ordinary income rate is. The rest of the gain, the other $13,000 in this case ($21,000 – $8,000) is treated as a capital gain by the IRS.

So, what’s the bottom line on this sale? You received a check from your buyer for $61,000, of which $8,000 is income, $13,000 is a capital gain, and $40,000 is completely non-taxable. You always get your adjusted basis back without having to pay tax on it. The gain is always divided into income and capital gain segments. For most sellers, the vast majority of the money they receive is tax-free and only a small percent is taxed at ordinary rates.

Why Do People Sell Their Policies?

Several scenarios lead to a person wanting to sell. For example, if you no longer feel you need the coverage, don’t want to continue paying premiums, or have the chance to get better coverage through an employer, you might decide to cash out on the current contract you hold. Note that both whole and term contracts can be sold. One of the persistent myths on this topic is that term contracts cannot be sold. In fact, they can be. People also sell their policies when they need funds to buy property, pay for a child’s or grandchild’s education, or take a major vacation. Depending how long you’ve had the coverage, what the original death benefit is, what the current cash surrender value is, and a few other factors, it’s possible to obtain a very large amount of money by selling.

What if You Withdraw Money from a Policy While it’s Still in Effect?

Your withdrawal, in most cases, will be considered to come from the basis first, which means you won’t pay tax on it. The IRS views such withdrawals as if you are simply taking money out of a savings account and leaving the interest intact.

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