Life insurance like we already know is a safety net to ensure your dependent doesn’t experience financial hardship when you are no more. In other words, life insurance is a necessity for people with dependents. The mind troubling question for policyholders (i.e. the person who took the life insurance) becomes, will Uncle Sam tax my life insurance proceeds? In responding to this question, first, I’ll highlight the concept of life insurance in a nutshell before responding to how it interacts with Uncle Sam.
What is life insurance?
Life insurance is a contract between two parties (i.e. the insurer and insured or policyholder), were for a present premium payment from the insured, the insurer promises to pay the insured’s beneficiary sum of money upon the death of the insured.
Is life insurance worth getting?
Probably, yes, if you have dependent(s) who you care for financially.
Types of life insurance policies
Generally, there are two major types of life insurance, namely– term and whole life. Whole life is sometimes called permanent life insurance, and it encompasses several subcategories within it.
Term Life Insurance
Term Life Insurance is the most common form of life insurance. It pays only if death occurs during the term of the policy.
Term Life Insurance (Term Policy) is the simplest form of life insurance. It pays only if death occurs during the term of the policy, which is usually from one to 30 years. To illustrate, suppose John (policyholder) has a term policy that covers him financially in the event of untimely death until the age of 40. Fortunately, if John lives past the age of 40, however, his term policy will not yield any beneficial benefit. Nevertheless, he could take remedial action by renewing the policy for another term.
Why buy term life policy?
Term policy is purchased by the policyholder to replace income supposing the policyholder dies so the policyholder’s loved ones can pay debts and living cost. To illustrate, if you and your spouse own a home and you were to die tomorrow, your spouse would have to pay for the mortgage alone. Supposing you have a term policy, your spouse may receive enough money from the policyholder’s death benefit to pay off or at least keep up the mortgage.
Pro: As a result of its low cost, compared to other types of life insurance, term life is a popular life insurance choice.
Con: Lower premiums when you are young, but premiums increase as you age.
Whole life insurance
Like term life insurance, whole life insurance (whole policy) also protects your loved ones from the financial hardship that might come upon them supposing untimely death befalls you. The significant distinction between a term policy and a whole life policy is the duration.
Whole policy is a permanent insurance policy guaranteed to remain in force for the life of the policyholder as long as the premium is paid timely. When you purchase a whole policy, you agree to a contract in which the insurance company promises to pay your beneficiary a certain amount of money, called a death benefit upon your death.
To illustrate, let’s say John buy a whole policy at age 35. When he purchased the whole policy, the premiums will be locked in for the whole policy as long as John pays his premium. Unlike a term policy, the whole policy doesn’t expire. The policy stays in effect until John passes or until it is cancelled.
What does life insurance cover?
The whole policy covers the entire life of the policyholder, in this case, John. When you have a whole policy, it will provide death benefits to your beneficiaries when you die.
Pro: Premium stay the same
Con: More expensive premiums
A quick checklist before purchasing life insurance
- Check the financial strength rating of the insurance company
- Decide on your duration for coverage.
- Calculate how much life insurance you need.
- Claims – check the national claims database to see what complaint information it has on your prospective insurance company
- Engage in forum shopping– The first step in comparing policies is to make sure you compare similar life insurance plans, based on your age, the type of policy and policy features, the amount of insurance you are purchasing
- Decide on your beneficiary
- Talk with a trusted financial advisor
Will my beneficiary pay taxes on proceeds received from my life insurance?
Generally, life insurance proceeds you receive as a beneficiary due to the death of a policyholder aren’t includable in gross income, as such you don’t have to report them. However, while the proceeds are income-tax-free, they may still be included as part of your taxable estate for estate tax purposes.
Section 2042 of the Internal Revenue Code states that the value of life insurance proceeds insuring your life is included in your gross estate if the proceeds are payable: (1) to your estate, either directly or indirectly, or (2) to named beneficiaries if you possessed any incidents of ownership.
Overall, this article an educational piece, as a result, should not be considered as any form of financial advice. Besides, consult a financial advisor for a well-tailored financial plan.