Life insurance comes in different flavors and shapes -- and some of them are taxable. Your beneficiaries may have to deal with income tax on the benefits, and in some cases, so will you. It's possible you could end up paying capital gains as well, but that won't be a problem for your beneficiaries.
As of 2013, estate tax is an issue if you leave behind $5.25 million or more. If your estate is large enough to trip the trigger, the value of your life insurance gets factored in. If you have a $250,000 policy, that's another $250,000 of assets subject to estate tax. You can avoid this by transferring ownership of the policy to someone else, but you have to do it more than three years before you die. Otherwise, it still counts as part of your estate.
If you take out a $250,000 policy and your beneficiary gets $250,000, there's no tax on the benefits. Benefits, however, can include interest on the value of the policy and that income is taxable. If your beneficiary gets a lump sum, she pays income tax on whatever part of the payment tops the face value. If the money comes out in installments, she has to calculate how much of each payment is interest and therefore taxable.
Some policies have a cash surrender value: you turn the policy in before you're dead and the insurance company gives you money. This is a taxable transaction, based on how much profit you make on the deal. If you've put in $60,000 in premiums and get $80,000 in surrender value, you have $20,000 in taxable income. You report the money as regular income, like wages or salary, and it is taxed accordingly.
If you sell the policy to someone else, any profit you make on the deal is taxable -- and some of it may be capital gains. For example, suppose you sell a policy for $90,000. You've paid $60,000 in premiums, and the cash surrender value is $80,000. In that case, $20,000 of your profits would be regular income and $10,000 would be taxable as capital gains. The IRS goes into the details in Revenue Ruling 2009-13.
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