The taxability of life insurance depends on two main factors. Are you the beneficiary of another individual’s policy, or are you surrendering your own policy for the cash value?
If you receive a payout because you were named as a beneficiary of a deceased individual’s life insurance policy, the distribution is generally not taxable.
This includes any proceeds paid out via an endowment contract, which is essentially a life insurance policy that may be paid out in death or as a single lump-sum after a specified period of time. Proceeds paid out to you from an accident or health-related policy are also generally shielded from taxation.
If the beneficiary is the estate, or if no beneficiary is named and the proceeds funnel into an estate that is created by the decedent’s assets, then the life insurance payout is taxable on both the federal and state level, and also may be subject to inheritance tax.
Most life insurance policies are used as an investment tool. These are considered whole-life policies, as opposed to a term life policy that is only in effect for a period of time. Whole life policies are purchased for a face value and have an accruing equity that can even be borrowed against.
If a whole life policy pays out its face value to the beneficiary, and on top of that pays out an additional amount because the cash value has matured, both the face and cash values are non-taxable to the recipient.
If you are the beneficiary of a life insurance payout, you can elect to receive the amount as a lump sum or in monthly installments. Either way, the amount is not taxable up to the total amount of the payout.
For example, if you are the recipient of a $150,000 payout, you can elect to take the amount in whole as a lump sum, which would not be taxable, or you may elect to split the sum up over time and reinvest the remaining amount.
If you choose to instead take the $150,000 payout over 5 years or 60 months, each monthly payment of $2,500 would be non-taxable, up to $30,000 per year. Any interest amounts received over and above that would be taxable to you.
If you yourself are cashing out or surrendering your own policy, then you will first need to determine the amount you will receive. Start with the current cash value, add any accrued dividends or unearned premiums, then subtract out any loans you have taken and the fees charged by the plan holder to turn it in early. The result is called the surrender value.
Compare the surrender value to the total annual costs you have paid into the policy. Include in your taxable income any amount over and above what you paid. You should also receive from the IRS a Form 1099-R that will show the total proceeds and the amount that is taxable.