How is life insurance
taxed?
Historically, life insurance has been accorded liberal tax
treatment. As insurance products have become more
sophisticated, however, the line separating insurance
products from investment products has become a bit more
complicated, depending on the type of policy(s) you own. As
a result, a mix of complex rules and exceptions now govern
the taxation of insurance products. Familiarity with these
rules will help you avoid an unwary consequences and help
you plan accordingly.
Tax considerations
Taxes are typically levied whenever cash changes hands.
During the term of any life insurance policy, there are a
number of occasions when money can and does change hands.
The only question is whether the transaction amounts to a
taxable event that triggers current income tax liability.
For instance, in most cases, premiums are paid with
after-tax dollars. To the extent they are deemed a return of
premiums, benefits paid out during your lifetime are usually
paid out tax free. Typically, death benefits are received
tax free by your beneficiaries after your death. But, the
sale or surrender of your policy during your lifetime
triggers a tax on the realized gain.
Premiums may be paid with pre-tax
dollars:
If your company offers the option to purchase life
insurance through a qualified retirement plan, then your
pre-tax contributions to the plan (and/or your company's
contributions) can be used to buy a life insurance policy.
However, not many companies offer their employees the option
to purchase life insurance through their qualified
retirement plan. If you do not purchase the insurance policy
through a qualified retirement plan, then the premiums have
to be paid with after-tax dollars.
Cash value accumulates tax deferred:
As the investment element of your policy grows, you realize
gains. Generally, you are allowed to defer taxes on those
gains provided you don't sell or surrender the policy. There
are a few rare--but important--exceptions.
Dividends are typically not taxable:
Dividends are paid out of the insurer's surplus earnings for
the year. Regardless of whether you take them in cash, or
keep them on deposit with the insurer, they are considered a
return of premiums. As long as you don't get back more than
you paid in, you are merely recouping your costs and no tax
is due.
Cash withdrawals in excess of basis are
taxable income:
When you begin to withdraw cash from a cash value life
insurance policy, the amount of withdrawals up to your basis
in the policy will be tax free. Your basis is the amount of
premiums you have paid into the policy. Any withdrawals in
excess of your basis will be taxed as income. If the policy
is classified as a "modified endowment contract,"
then untaxed earnings must be withdrawn first and taxed.
Keep in mind, though, that only certain types of cash value
policies even allow withdrawals in the first place.
Policy loans usually not taxable:
If you take out a loan against the cash value of your
insurance policy, the amount of the loan is not taxable
(except in the case of a modified endowment contract). This
result is the case even if the loan is larger than the
amount of the premiums you have paid in. Such a loan is not
taxed as long as the policy is in place.
Interest on policy loans usually not
tax deductible:
The interest on any loans you take out against the cash
value of your life insurance is usually not tax-deductible.
Surrender of policy may result in
taxable gain:
If you surrender your cash value life insurance policy,
any gain on the policy may be subject to federal (and
possibly state) income tax. The gain on the surrender of a
cash value policy is the difference between the net cash
value and loan forgiveness amounts and your basis in the
policy. Your basis is the total premiums you paid in cash,
minus any policy dividends and tax free withdrawals that you
made.
Policy exchanges are typically not
taxable:
The tax code allows you to exchange one life insurance
policy for another without triggering current tax liability.
However, you must follow the IRS's rules when making the
exchange.
Death benefits usually not subject to
federal income tax:
Whoever receives the death benefits from your insurance
policy (at the time of your death) usually does not have to
pay federal income tax on those proceeds. Thus, if you die
owning a cash value life insurance policy with a $500,000
death benefit, then the beneficiaries under the policy will
generally not have to pay any federal income tax on the
receipt of the $500,000. In addition, the payment of death
benefit proceeds from a cash value life insurance policy to
a beneficiary is usually not considered a taxable gift.
Insurance proceeds may be included in
your taxable estate:
If you hold any incidents of
ownership in an insurance policy, the proceeds from that
insurance policy will be included in your taxable estate.
Furthermore, if you gift away an insurance policy within
three years of your death, then the proceeds from that
policy will be pulled back into your taxable estate.
Incidents of ownership include the right to change the
beneficiary, the right to take out policy loans, and the
right to surrender the policy for cash.
Learn More...
Life
Insurance Overview | Understanding
The Basics | Term
& Cash Value
Coverage Amounts
| Reading Policies | Planning
Concerns | Life
Calculator | Life Glossary
Please Note: The
information contained in this Web site is provided solely as a source of
general information and resource. It is a not a statement of
contract and coverage may not apply in all areas or circumstances. For a complete
description of coverages, always read the insurance policy, including
all endorsements.
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