As life insurance is considered a beneficial investment for the security of Americans, the Internal Revenue Service, IRS, grants special tax treatment to many aspects of insurance contracts. However, there are instances in which life insurance distributions can be considered taxable income. Generally, any contract proceeds that can be considered an investment gain may be taxable as ordinary income. The IRS publishes explicit instructions as to how life insurance proceeds should be taxed.
Contributions
Purchases of a life insurance contract are made with after-tax dollars, meaning you cannot take a tax deduction when you buy or contribute to a contract.
Death Benefit
Life insurance proceeds paid as a lump-sum death benefit are tax-free to the recipient. If you take a death benefit as a series of payments, the unpaid balance remains with the insurance company and generally earns interest. Thus, death benefits paid out over time may ultimately result in a higher overall payment than you would have received in a lump-sum. If this is the case, the additional amount you receive will be taxable at ordinary income tax rates.
Annuity Payments
Annuities are life insurance products that typically pay regular interest payments in lieu of a traditional death benefit, although some annuities offer a death benefit feature. Annuity payments are taxed through the use of an exclusion ratio, in which a portion of your distribution is taxable and a portion is tax-free. The tax-free amount is calculated by dividing the amount of your original investment by the total value of the contract. For example, if you invested $100,000 in an annuity and the annuity value grows to $400,000, then 25 percent of each payment you receive will be considered a tax-free return of original principal.
Liquidations
If you sell an annuity or straight life insurance policy, the accumulated value above your original investment will be taxable at ordinary income.
Penalty Taxes
In addition to any regular tax consequences, the IRS will impose a 10 percent penalty if you liquidate any insurance contract before you reach the age of 59 1/2. If you are the recipient of life insurance proceeds, this penalty does not apply.
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