When the person covered by a life insurance policy dies, beneficiaries of the policy often wonder whether Uncle Sam will take a cut of the proceeds for income or estate taxes. But dying isn't the only way to tap the value of a life insurance policy and bear tax consequences: Withdrawals and loans against cash-value policies may also be taxable, either immediately or in the future.
Death Benefits and Income Taxes
Unless you paid to purchase someone else's life insurance policy, which is uncommon, you won't have to pay any income taxes on the proceeds. For example, if your spouse names you as the beneficiary of a policy on her life, you receive the death benefits of the policy tax free when she dies. However, any interest paid to you on the death benefit between the date of death and the date the insurance company cuts you a check does count as taxable income.
Death Benefits and Estate Taxes
Life insurance proceeds are not included as part of a decedent's estate unless the decedent owned the policy or the estate was the beneficiary. If the policy is owned by someone else and names someone else to receive the death benefit, those policy proceeds are excluded from the decedent's taxable estate and avoid estate taxes altogether. For example, if you buy a policy on your own life and name your spouse as the beneficiary, the proceeds will be included in your estate. But if your spouse had bought the policy on your life and named herself the beneficiary, the proceeds wouldn't be included in your estate.
Cash Value Withdrawals
If you have a whole life policy that has accumulated a cash value, you may be able to withdraw from your policy. As long as your withdrawals as a whole do not exceed the amount of premiums you've paid, each withdrawal continues to be tax free. However, once your withdrawals equal the amount of premiums you've paid, any future withdrawals count as taxable income. For example, say you've paid $12,000 in premiums on your policy and you took out $5,000 last year. The first $7,000 you take out after that is tax free, but any cash value withdrawals in excess of $7,000 count as taxable income.
Life Insurance Loans
Instead of withdrawing money from your life insurance policy, you might consider taking a loan against the cash value of your policy. As with other loans, the Internal Revenue Service doesn't consider the amount of the loan to be taxable income when you withdraw it. However, if you let the policy lapse, the IRS treats you as having taken enough cash out of your policy to pay the balance of the loan. If that amount exceeds the amount you've paid in premiums, the excess counts as taxable income at that time even though you weren't actually paid any money.