The taxation of life insurance proceeds depends on several factors. Under IRS regulations, life insurance death benefits are not taxable, but if you cash in a policy before the death of the insured, you may incur taxes in some circumstances.
Death benefit proceeds received over time are subject to tax on any interest component of your payment. If you divide the death benefit amount by the number of payments you will receive and subtract that amount from your payment, the difference is taxable interest, according to the IRS.
Cash-value life insurance policies have a cost basis. The cost basis is the sum of all payments you have made, less any dividends you have received. Loans you have taken from the policy and have not repaid increase your cost basis.
Calculating Taxable Gain
You can calculate taxable gain by subtracting your cost basis from the proceeds you will receive upon surrender of the policy. If the cost basis exceeds the surrender proceeds, there are no tax implications. The amount by which surrender proceeds exceed cost basis is taxable.
Policy cash value, surrender proceeds and tax implications all go to the owner—not the insured. Insurance companies are required to provide the owner with an IRS Form 1099-R showing both the amount of total distribution and the taxable portion.
Tax rules for employer-owned life insurance policies, such as split-dollar and reverse split-dollar plans, are more complex. Consider consulting a tax adviser regarding tax treatment of these plans.
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