Is Life Insurance Taxable? | Guide to Understanding Life Insurance Financials

What is Life Insurance & How Does It Work?

Life insurance is a legal contract between you (the insurance policy holder) and an insurance company. The contract is an agreement that states that upon the death of the insured person the insurer (insurance company) promises to pay a designated beneficiary the death benefit (usually a lump sum of money) in exchange for premium payments.

In a sense, life insurance is a protection against the unknown. It’s generally invested in by people to provide money for their loved ones in case they die young or due to an unforeseen accident. Especially if the policy holder is the main financial supporter in a family. Life insurance will provide an income to replace yours so that your family can continue to live comfortably without any financial worries. On top of this, life insurance can also be used to cover expensive funeral costs, or for medical or legal costs.

Premium payments can be paid monthly, quarterly, annually or as a lump sum for the term of the policy. The term is decided by you in the contract and can be as short as a year or for your entire lifetime. If death does happen during the term of your policy, your beneficiary (or beneficiaries) will then receive the fixed amount of money from your policy.

Do I Need Life Insurance?

Probably one of the biggest questions around life insurance is “Do I need it?” As a quick response, if you have a family or if someone will suffer financially if you die, then most likely, you need life insurance. Why? Because if (and more importantly when) you do die, they will be provided and cared for in your absence.

Other situations where you will want to invest in life insurance include if you’re married, a single parent, single, retired, a stay-at-home parent, have grown children, or a small-business owner.

Other Situations for Needing Life Insurance

• If You’re Married or a Single Parent

  Kids aren’t the only ones who will benefit from a life insurance policy, which is why those other situations are just as important to invest in a policy. If you’re married and die young, your surviving spouse’s income may not be enough to cover funeral costs, or standing debts from credit cards, loans or other bills. As a single parent, the idea of having a life insurance policy is a big no brainer, you’re the main source for income for your children and they rely upon you heavily for, well, everything.

• If You’re a Stay-at-Home Parent, Retired, or All Your Children Are Grown

  If you’re a stay-at-home parent, you might also want to consider taking out a policy. Just because you don’t provide income doesn’t mean you don’t also provide just about everything else for your family — from cooking, cleaning, transportation, to childcare your family relies upon you just as heavily as they do your spouse’s paycheck. If you’re either retired or all your children are grown, having a policy is again another way to help any surviving members of your family to pay for daily living expenses, funeral costs, taxes or any standing debts.

• If You’re a Small-business Owner or Single

  The last two categories: small-business owner and being single are a bit different but not by much. Many single people take care of elderly parents or family members with special needs, or you may have surviving debts that will need to be settled upon your death. Having a policy will cover any bases you left uncovered. If you’re a small-business owner, a life insurance policy will not only protect any family but also your business upon your death. Having a policy can help fund a buy-sell agreement (this ensures remaining business owners will have the funds to buy the company interests of a deceased owner). Through this policy, your family will receive the much-needed cash and your partnering business owners will get the business and can continue without you.

What Type of Life Insurance is Best for Me?

Like above and below, knowing what kind of life insurance policy to get greatly depends upon you personally and your circumstances. No matter where you’re at in life, the best place to start will be to conduct a needs analysis. There is a plethora of online insurance calculators you can use to get a general idea, or speaking with an agent can also be far more beneficial. Don’t worry about getting trapped into a policy though, it is actually recommended that policy holders review their policies every 12 to 18 months — circumstances and lifestyles change so often that staying up to date on what you need is a big deal. You could lose your job, or get a big promotion, there could be a surprise baby or death of a spouse, or a recent terminal illness that would require a larger policy for your children in case you too pass.

If you’re trying to figure out what kind of policy to get, consider these different types of life insurance below or speak to an insurance agent.

Types of Life Insurance

There are three different types of life insurance: term, universal and whole.

• Term: Term life insurance is probably the most basic and easy insurance policy to understand. If provides all the coverage you will need. Unlike universal or whole life policies, term life is a policy only set for a specific period of time. You can choose between one year, 10, 20 or to a specific age (usually 65). However, if you die after the term you’ve chosen there will be no payout for your beneficiary. With a term policy, the benefit payout is the same amount if death occurs at any time during the term. The premium is usually based on your age and health at the start of your policy and it remains the same for the entire term.
• Universal: Universal life insurance is a more flexible permanent insurance that combines the low-cost of term insurance and the savings element that comes with whole life insurance. Universal also allows you to use any interest from your accumulated savings to pay for premiums. With universal, you can move money between the savings and insurance components of your policy depending upon individual circumstances. Unlike whole, universal lets the cash side of investments to increase at a mutable rate that can be adjusted monthly. Universal premiums can also be changed as needed.
• Whole: In contrast, whole life insurance has a fixed premium that cannot be adjusted, but you can make withdrawals or take out loans against your policy. Similarly to universal though, whole life is a permanent policy unlike term and can accumulate a cash value over time that will create an amount you could potentially borrow against. Like universal too, growth from cash value is tax-deferrable. Along with this, the benefit of having a fixed premium allows for easier budgeting and planning.

How Much Life Insurance Do I Need?

Picking how much life insurance to get can be a bit of a hassle. Many factors are involved in this decision, including your age, income, debts and/or mortgage, ages of your children and spouse, size of the last bill you’ll incur — funeral expenses —, and any college expenses for your children and/or spouse. You also have to consider how many people depend on you financially: whether you have one child or three can affect how large you need that benefit to be. It also depends on the state of your finances. If you were no longer around, would your kids have enough money to get them through college? Would your family be able to make mortgage payments on your house? If you simply don’t know how much you need, it’s always a good idea to sit down with a professional to determine the right amount of life insurance.

How Much Does Life Insurance Cost?

Calculating life insurance can be a bit tricky since there are several factors that will affect the cost. These factors include age, overall health, gender, exams, and even your occupation. Of course, the healthier and younger you are, the lower your premium will be. For cash-value policies (like universal), premiums are much higher than term policies. Here are some average costs for whole life insurance to help you get a feel for what you could be spending (these averages are based on nonsmokers with a healthy weight and safe lifestyle who want $500,00 worth of insurance).

For term life (for a 20-year term policy):

*The best way to gauge how much life insurance will cost you is to compare different life insurance rates.

What is a Life Insurance Beneficiary & How do I Choose One?

A life insurance beneficiary is the person and/or entity who will receive the benefit of your policy upon your death. A beneficiary can be one or more people (for instance, if you have several surviving family members such as children), a charity, your estate, or a trust. You can choose a primary and secondary beneficiary. Your primary is the first to receive your death benefit; however, if your primary passes before you, a secondary beneficiary will be next in line. You can also choose a “final beneficiary” to receive your death benefit if both the primary and secondary beneficiaries pass before you. Choosing a secondary beneficiary is beneficial especially if your primary is your spouse and upon the terrible incident that both you and your spouse pass at the same time.

Picking a beneficiary is generally a very personal decision, whether you see it as a way to protect loved ones or if you see it as a financial transaction. Some good things to think about as you decide who your beneficiary is, are: who most relies upon your financial support? Who might need extra money in the event of your passing? Who will bear the expenses at your death? It is important to note that there are state and policy restrictions that might offer restrictions to who you can name your beneficiary.

There are several ways to pick a wrong beneficiary so keep these common mistakes in mind: picking a dependent ineligible for government benefits (such as a child with special needs), picking a community-property state over your spouse (in some states, a spouse will have to sign a form waiving his/her rights to the money if you choose someone else as your beneficiary), choosing a minor child as beneficiary, not picking someone, forgetting to update or specific details (don’t just say “my children,” include names, SSNs, etc.), or naming only a primary beneficiary. These are all some common mistakes that you should absolutely avoid when choosing a beneficiary for your life insurance.

(Note that you can change whomever is your beneficiary at any time.)

Is Life Insurance Taxable?

Many beneficiaries of life insurance policies worry about the taxes faced with a sudden, new income. However, if you are a beneficiary of a policy, the benefits are not included in your gross income and do not need to be reported on your tax forms. But, any interested you might receive is taxable and you will need to report that.

If a policy is transferred to you for cash, an exclusion of the proceeds will be limited to the sum of what you are paid, any additional premiums paid, and other amounts. According to the IRS, taxable amounts should be reported according to the type of income document received (Form 1099-INT, Form 1099-R, etc.).

How to Avoid Probate and Estate Taxes on Life Insurance

Generally, any proceeds of a life insurance policy are not subject to probate taxes. That is unless you name your estate as the beneficiary. Probate is a process supervised by the court that follows a death that includes identifying an heir, authenticating the deceased member’s will, appointing someone to handle their affairs, identifying and inventorying the deceased member’s property, paying taxes and debts, and finally, distributing remaining property according to the deceased member’s will or state law. The process tends to be time-consuming and extremely costly, but if you name an individual or trust as the beneficiary then the proceeds of your policy won’t be included in the probate estate. This way the benefit can be easily transferred with little cost or delay.

For estate taxes, if your estate is at least over $2 million, your policy will be subject to an estate tax. This is, of course, if you own your insurance policy at the time of your death. If you do not own it at the time of your death, the benefit will be exempt from any part of your taxable estate. By transferring your life insurance policy, you can decrease your death tax liability and avoid estate taxes.