When planning for the future, a number of financial questions may arise; one of the most common is: “Do you pay taxes on life insurance benefits?” The question is more complicated than it might seem at first. The answer is both yes and no, and depends on the amount of the payment, the type of payment, and the way in which the payments are received.
Generally, life insurance benefits themselves are not taxable by the federal government. For instance, if a policy’s face value is $25,000, and you accept $25,000 as a lump sum payment from the insurer, none of that money is subject to income tax. However, if the payment is more than the face value of the original life insurance policy, then the additional portion is taxable. For instance, if you elect to receive the life insurance payment in installments, interest may accrue on the amount not yet paid and is usually distributed with the installments. While benefits are not taxable, since they are simply the return of money already paid in as premiums, the interest portion of the installment is taxable and should be reported on your income tax return during the year it was received.
Calculating what portion of your life insurance benefits is taxable and what portion is exempt from tax is usually a simple matter. By dividing the full face value of the life insurance policy by the number of installments, you can derive an accurate value for the tax-free portion of the insurance payments. Any additional amount is interest, and is taxable as income. One intricacy of the situation is that interest becomes taxable when you can withdraw it, not necessarily when you decide to do so. For example, if you could withdraw $200 in interest from life insurance benefits, and you chose only to withdraw $100, you’re still liable for the full $200 from a tax perspective. So, do you pay taxes on life insurance benefits? In most cases, the answer is no; in some specialized situations, however, you may pay taxes on interest, but not on the actual benefits themselves.