Life Insurance Q&A – Life Insurance Policy Taxation

Question:  My mother recently passed away and I inherited a substantial amount from her life insurance policy.  With April 15right around the corner, how much should I allow for taxes?  Rhonda

Answer:  My condolences regarding your mother.  The good news is that you don’t have to pay income taxes on life insurance proceeds.  Therefore, your concern about April 15 approaching really shouldn’t be a factor at all as it relates to money received from your mother’s life insurance policy.   However, there is a circumstance that I occasionally run across with clients that could cause money received from a life insurance policy to be taxed.  When the insured surrenders a cash value policy (cancels it before death), they could potentially trigger a taxable event.  If the policy’s cash surrender value exceeds the premium paid into the policy, the policy must remain in force to avoid being taxed.  In other words, if you paid $75,000 into a permanent cash value policy and the surrender value is now $500,000, you would be responsible for taxes on the $425,000 in earnings upon surrendering the policy.  One way to avoid getting taxed in this situation would be to take cash out of the policy in the form of a loan and never pay it back.  Although you would pay interest on the loan, many insurers actually credit back part or even all of the interest paid.  With the right insurance company, this could translate into no interest AND no taxes for the insured.  Another technique to effectively cancel a policy and avoid current taxes would be to execute a 1035 exchange into another insurance product such as an annuity.  In this case, the cash value would actually transfer tax free to the annuity and grow tax deferred until withdrawn.  Enjoy life!

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