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Life Insurance Benefits Aren’t Taxed (Usually)

Posted By Jim On 01/07/2010 @ 12:04 pm In Insurance | 34 Comments

I was poking around on the internet the other day when I saw one of those morbid life insurance policy ads. You’ve probably seen them before too. They usually have someone kneeling at a grave or a kid wearing all black at a funeral. They ask you the pointed question of – “If you died today, who would take care of your family?” I suspect they’re trying to tap into your fear of the unknown, how your kids won’t be able to fend for themselves or how your husband or wife is going to be lost without your financial support.

First of all, my lovely wife is quite capable and she can take care of herself. I bet she’d miss my sparkling personality but after a while she’d probably be OK with it.

Second, our dog Tobey is the fiercest beagle in all the land. He’d do fine finding his own rawhide cow ears and kibble. Just the other day we left some food on the table and he managed to to jury-rig a Rube Goldberg-contraption just to get at it.

Life Insurance Death Benefit

OK, all kidding aside, life insurance is important but we haven’t looked at it yet. As I was about to tweet a joke about the ad’s morbidity, I wondered about whether life insurance benefits were taxed. As it turns out, life insurance death benefits are not taxed. Implicitly this made sense because auto insurance claims payouts aren’t taxed either. If you crash your car and the insurance company reimburses you, you don’t claim that payment as income on your tax return.

The same holds true for life insurance. It’s not obvious because your life doesn’t have a set dollar value like a car does. A particular repair will cost you a specific amount because you can go to a repair shop and get a quote. If it’s totaled, the pre-accident car could’ve been sold for a certain amount on the open market. You can’t really do that with your life, so we don’t really think about it in those terms.

If you receive more than the life insurance death benefit, then the excess is taxable and should be included on your return. If the benefit was $50,000 and you get $60,000, then $10,000 is taxable. If you get it paid out in regular installments, you can divide the total benefit by the number of installment payments to find out how much of each payment is not taxed. For example, if your benefit is $500,000 over 10 years, then $50,000 of annual life insurance death benefits is tax free.

Life Insurance Dividends

Here’s where things get a little tricky – life insurance dividends are only taxable if:

  • The amount you receive in cash is more than the amount of premiums you have paid,
  • You take the dividends as cash, as opposed to buy additional coverage,
  • Your policy is a modified endowment contract [3], which is a special kind of policy, and you take cash.

Life insurance can be a tricky subject, especially since there are so many plans and policies out there, so I recommend you talk to an expert before rely on anything this novice as written. As for tax treatment, a financial advisor or a tax expert will be able to give you the ins and outs of everything much better than me!


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[3] modified endowment contract: http://en.wikipedia.org/wiki/Endowment_policy#Modified_endowments_.28U.S..29

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