I am often asked this question, “do I have to pay taxes on life insurance payouts” and it often comes during a time when clients are in no position to receive the information. The answer of course is not simple, as it depends. Losing a loved one is hard and trying to get your finances in order can be harder. Understand before something happens that there are a wide range of settlement options available to you when you go to collect the life insurance benefit.
The first and most obvious choice for most people is to take the lump sum option. Not only do you get control of the money quickly but you receive it tax free. By having the money as a lump sum you get to be in control, whether that is buying an annuity, investing the money or paying down debt, the lump sum puts the flexibility on your side.
Verdict: Tax Free
But, there are alternative options to lump sum that most people don’t know about.
For example, there is an interest only option which pays out interest from the benefit that the insurance company will hold. This is generally is not a permanent set up though, as you will need to set up another payment option within a year or two. For this option the insurance company is in control of the money per se as they send you the interest payments from whatever investments they are using to generate them.
This option is easy to remember as it is interest and any interest is taxable to you, so it is the same with this option.
Two other options keep the insurance company in control of the money.
Installments for a Fixed Period and Fixed Amount
Both these options are used as they are described. The option is to let the insurance company handle the payouts to you so as to make sure you will receive the money in a fixed amount or time. This is really if you need hand holding or don’t like the idea of getting the money right away. Of which I have never heard anyone doing, but hey, you have the option! These options will each be taxed as a portion of the payout because they will include interest in the payments to you.
Verdict: Partially Taxable
The final option is the life income option, think annuity payout. As it sounds, this option will give you lifetime income, albeit in smaller amounts. Since the insurance company has to make the amount last they will be using the money to investment and pay you a fraction of the investment each month. This too has a portion that is taxable to you because of the interest being used in the payment.
Verdict: Partially Taxable
There you have it. Instead of making a decision based around emotions you can remember these specific payouts and have an idea in your head of how you would like to receive income if at you did have that option.
If you are still unsure, find help. We all need help as I just wrote in my last article “How Turbulence Taught Me About Getting Help.” Find an independent insurance agent to help walk you through your specific situation and goals. Just do me a favor and don’t neglect this important piece of actually buying life insurance.