Life Insurance and Taxes

You may read or hear that life insurance is "generally" tax free.  In brief, what this means is that proceeds from a life insurance policy (death benefit or cash value) can completely avoid taxes in most cases.  Read on to learn the particulars.

Contents
Estate taxes
Income taxes
Premium taxes
Gift taxes
Capital gains taxes
Federal restrictions

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Estate taxes

The death benefit is not exposed to estate taxes if the insured is not the beneficiary and possesses no incidents of ownership.  It is common to designate a trust or a family member as policyowner and beneficiary.

Nevertheless, estate taxes are of concern to life insurance customers because life insurance is often bought with some intent of covering estate taxes.  When an individual receives an inheritance, sometimes there are no funds to pay estate taxes on the inheritance, and the bequest (whether it be a business or an heirloom) must be liquidated for the sake of taxes.  Life insurance keeps an estate intact.

You can even prevent the value of the life insurance policy itself from being counted as a taxable property by making use of a Crummey note.

Income taxes

Death benefit

A death benefit is not taxable as income.

Cash value

Your cash value may grow, and you may make use of it without ever paying taxes.  This tax exemption is notable, since interest earned on other financial products is subject to income tax.  However, there are exceptions:

Cash value in excess of cost basis

If your cash value grows to exceed your cost basis and if you access your cash value through withdrawal or surrender in excess of your cost basis, then that excess is subject to income tax at the time it is accessed.  In other words, every dollar you take in excess of what you paid is taxable as income.

Policy loan and lapse

You can procure a policy loan tax-free.  However, if your policy lapses while the loan is outstanding, the outstanding amount becomes taxable income.

1035 tax-free exchange

Changes in your financial situation may prompt you to replace your current life insurance policy with a new one.  In such a case, you may transfer the cash value from your existing policy to the new one without exposure to income taxes.

Premiums

Life insurance must be purchased with after-tax dollars.  In other words, you cannot claim premium payments as a tax deduction.

An exception is when a company pays the premiums for an employee and classifies them as part of his or her salary.  The premiums become a tax deduction for the company, but the employee is taxed for the value of the policy.

Dividends

Participating policies distribute dividends to policyowners.  The dividends are considered a partial refund of your premium and are not taxable.

An exception is if you receive dividends in excess of your cost basis: the excess is taxable income.

If you allow your dividends to accumulate interest, said interest is not part of your life insurance policy.  It is taxable income.

Premium taxes

Some state governments impose premium taxes.  You’ll not actually see these taxes, however, because it is the insurer who pays them.

Gift taxes

If a party who is not the policyowner supplies part or all of the cost of the premiums, those funds may be considered gifts for taxation purposes.  Gift taxes apply if the gift is in excess of the allowable amount (currently $13,000 per recipient per donor).

Capital gains taxes

This is less usual, but a policy may be classified such that proceeds are taxable as a capital gain instead of as income.  In determining exposure to capital gains taxes, the guidelines in the Income taxes section above apply.

Federal restrictions

In order to enjoy  life insurance’s tax-advantaged status, your policy must abide by certain tax code guidelines.  Your agent will illustrate these guidelines for you.  (Click here to learn more.)

This page is not intended to replace expert or legal counsel, nor personal perusal of the Internal Revenue Code.