Life insurance is a great way to leave your loved ones a financial safety net after you pass, but you don’t want those good intentions to become a tax burden. You can rest easy that, most of the time, life insurance proceeds are not considered taxable income. There are some exceptions to this, however. Bankrate has broken down how life insurance proceeds are taxed so that you can make an informed choice for yourself and your family.

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Are life insurance proceeds taxable?

You may be wondering, “Is life insurance taxable?” The IRS states that proceeds from a life insurance policy are not generally considered gross income for the beneficiary. However, there are exceptions. For example, interest received by a beneficiary as a result of the insured’s death should be reported as income. A beneficiary may also need to report some of the payout as taxable income if they receive it in exchange for cash or something else of valuable consideration, up to the total amount of what was expended.

There are some exceptions when you may have to pay tax:

When the payout comes in installments instead of a lump sum

There are two ways the benefit can be paid — as a single lump sum or in installments. Some people prefer to receive money over time to avoid spending the full amount. But they should be aware that the interest is taxable.

Jonathan Holloway, co-founder of NoExam.com, a digital life insurance brokerage explains, “If the payout is paid in installments, the interest that accrues on the payouts is taxable. The death benefit is not taxable, only the interest on installments.”

If the beneficiary is an estate

If the policyholder names an estate as the beneficiary in a life insurance policy, the process gets more complicated. If the death benefit pushes the estate’s value over $11,700,000, your beneficiaries will have to file an IRS Form 706, also named the “United States Estate (and Generation-Skipping Transfer) Tax Return.” Leaving the proceeds to an estate adds to its value, which could lead to higher estate taxes for your heirs.

The proceeds left to a beneficiary may be taxable under the decedent’s estate, both Federally and on the state level in some cases, as well. An estate tax may also be owed in cases where the beneficiary is not the estate.

When you leave a cash value policy

This one may not be a taxable issue, but still affects the beneficiary. The policy owner can borrow against the funds in a cash value policy. If you borrow against your policy and don’t pay it back, the insurance company will deduct what you owe before they pay out the death benefit.

A cash value policy where paid premiums are greater than the amount permitted in order to maintain full income tax treatment is called a modified endowment contract (MEC). With an MEC, cash value distributions are first deducted from taxable gains, as opposed to distributions which are taken from non-taxable contributions. In other words, when a life insurance policy is determined to be an MEC, tax-free withdrawals are not available from the policy’s cash value.

Cash value policies can impact beneficiaries in other ways, including the following scenarios:

  • Exchange of cash value for a death benefit increase – Typically, at death, the cash value of a whole life policy reverts to the life insurance company. Most companies will honor an insured’s request to convert a portion of the cash value to a death benefit.
  • Life insurance premiums paid from cash value – An advantage for the insured is that once cash value has accumulated to a certain point, it can pay toward ongoing premiums. This can reduce the insured’s monthly expenses, but will also reduce the life insurance payout for the beneficiary.
  • Loans from cash value – An insured can borrow from the cash value of a policy. Upon death, any outstanding balance on the loan will reduce the beneficiary’s life insurance payout accordingly.

What should you do with life insurance proceeds?

There is no set rule about what you should do with your life insurance proceeds. It may be tempting to go on a spending spree when you first receive the money, but putting off spending for a while and consulting with a financial advisor may be a wise choice.

Thomas D. Currey, owner of TDC Financial Services in Grand Prairie, Texas, and chair of the board of directors of the nonprofit Life Happens, warns individuals to be careful with their newly acquired windfall. “The one word of caution I’d have is that when anyone comes into a large sum of money, it’s easy to spend first and ask questions later,” Currey says. “Seeking counsel to help you assess what your current needs are and how to make it go as far as possible is always a good idea.”

You already know the scenarios that answer the question “is life insurance taxable?” As for what to do with the death benefit, here are some ideas:

Pay off high-interest debt

If you have credit card debt or you’re paying off student or personal loans with high-interest rates, paying off the debt can save you money on the interest you’re paying. It helps to be systematic in this process. Prioritize debts according to the highest interest rates charged and pay these first.

Set money aside for your children’s education

Create a college fund for your kids by putting some money into a 529 college savings plan. The funds can be withdrawn tax-free to pay for qualified school expenses. If possible, when paying for education, use any available tax credits first. After this, consider using 529 funds on remaining expenses, while watching out for penalties. You need to withdraw 529 funds during the year they will be used for school expenses.

Create an emergency fund

If you’re living from paycheck to paycheck, an emergency fund could take some of the pressure off. You should have between three and six months worth of living expenses in your emergency fund to cover your cost of living if you lose your job, your car breaks down or you become ill and unable to work. In creating a sufficient emergency fund, use the adage “pay yourself first.” You could agree to pay a set amount into the fund each month before any other bills are paid.

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