Annuities

• Life insurance is sometimes paid as an annuity. In this case, the death benefit will earn interest, which is taxable. For example, the death benefit might be $500,000, and the proceeds paid in the form of a 20-year annuity. If the annuity pays 3 percent interest, you will receive a monthly payment of $2,772.99. Of this, $689.66 is interest, and this amount is taxable.
  
  

Life Annuities

• Insurance benefits may also be paid in the form of a life annuity. A life annuity is a series of regular payments that are paid to you for as long as you live. In this case calculating the expected term of payments is a bit more involved. Here is an example to help your understanding. A 50-year-old female inherits a $500,000 life annuity. Using an actuarial life table published by Social Security online, her life expectancy is 82.49 years, or, on average she will live another 32.5 years. If the interest on the annuity is 3 percent she will receive $2,008.52 per month. Of this, $726.47 is interest and is therefore taxable.
  
  

Calculating The Interest Portion

• To calculate the interest portion for both a term certain and life annuity, Take the amount of each payment and multiply by the number of payments. Then subtract the initial death benefit. Take that difference and divide it by the number of payments. Here is the life annuity example again:
  
  Amount of each payment = $2,008.52
  
  Multiply by the number of payments = 32.5 years x 12 payments / year = $783,323.26
  
  Subtract the initial death benefit = $783,323.26 - $500,000 = $283,323.26
  
  Divide by the number of payments = $283,323.26 / (32.5 * 12) = $726.47
  
  This is the interest portion of each payment, and is the taxable amount.
  
  

Accelerated Benefits

• Your life insurance policy may offer an accelerated benefit. An accelerated benefit is a payment made prior to your death. If you are terminally ill (expected to die within 24 months), these payments are not taxable. Accelerated benefits may also be paid if you are chronically ill. When used to pay for long-term care at a qualified facility, these payments are typically not taxable, although in some cases the IRS may apply limits. Even if your insurance policy does not provide accelerated benefits, you may still arrange them via a viatical settlement.
  
  

Considerations

• Some life insurance policies have a cash value. If you surrender the policy and receive more money back than you paid in premiums, the additional amount is taxable. Business owners who receive a death benefit from an employee should consult with an accountant. If you have, or are considering, a split-dollar life insurance policy, read sections 1.61-22 and 1.7872-15 of the IRS regulations.