Tax benefits of life insurance

5 Unique Tax Benefits of Life Insurance

Happy Tax Day!

Hopefully you got everything done in time, and now you can just relax and start planning for next year…

If you’re looking for a way to reduce your taxes, you may not have considered life insurance. And indeed, opening a life insurance policy today in most cases will not reduce your current tax burden. However, it could have significant benefits down the road. Today we are exploring a few of the major tax advantages that a well-structured life insurance policy can provide.

Cash value life insurance receives some special treatment when it comes to taxes – particularly income tax.

Here are a few considerations to keep in mind when doing your tax planning:*

1.) The death proceeds of a life insurance policy are typically not considered taxable income to the beneficiaries, no matter how long the policy has been in force, or how large the death benefit is.  (However, they may be subject to estate tax – more on this below. Also, Modified Endowment Contracts (MECs) are treated somewhat differently – see IRS Code Section 7702 and Section 7702A.)

Once the proceeds are transferred to the beneficiary, however, any growth would become taxable, so beneficiaries should keep this in mind if they are opting to take a settlement option, rather than a lump sum payment.

2.) During the policy owner’s lifetime, growth in the policy’s cash surrender value (CSV) is not considered taxable income as long as the policy is in force (not surrendered), and the owner is not withdrawing cash from the policy.

3.) If withdrawing cash value from an in-force non-MEC life insurance policy, the cash value will not be taxable until it exceeds the amount which was paid into the policy (cost basis), at which point, the gains will be taxed as ordinary income – not capital gains.

However, if the cash value is borrowed from the policy as a loan, in most cases it will not be taxed (as long as the policy is not a MEC, and the policy is not surrendered; if the policy is surrendered with outstanding loans that exceed the cost basis, tax may be due on the gains, including any outstanding loans that exceeded the cost basis).

4.) Dividends earned within the policy also are not taxed, as they are considered a “return of premium” rather than a gain. The interest earned on compounding dividends however can be taxed, but if the policy is properly structured (to apply dividends to purchase paid-up additions), this should not be an issue.

5.) In some countries, such as Europe and Japan, premiums paid for individual cash value life insurance may be at least partially tax-deductable. However, this is not the case under current U.S. tax law – though it would certainly be nice!

While this may not be a current benefit here in the States, by pre-paying your taxes on your premiums now, you can reap the benefits of tax-deferred growth on your CSV (similar to a Roth IRA). If you then use the proper strategy to take income from the policy during your retirement years, it may be possible to avoid paying taxes on the withdrawals entirely (be sure to consult with a qualified advisor before attempting this).

A Note on Estate Tax:

There seems to be some confusion out there about this matter, so hopefully this quick summary will clear things up for you.

While the death benefit of a life insurance policy might not always be subject to estate tax, it can be.  The proceeds of the policy are typically included in the estate of the insured, and thus they are subject to taxation in the taxable portion of the estate.

Estate tax applies to estates that meet a certain size threshold which changes year-to-year. (In 2016, it is $5.45 Million.)  If you have a large life insurance policy, as well as other assets, your estate may be subject to estate tax. Under current law, you may transfer the ownership of your policy to someone else, or to an irrevocable trust, to avoid estate tax on the policy proceeds – as long as the transfer is made more than 3 years before your death. There are also exclusions for spouses as beneficiaries. (Learn more about this topic here.)

However, if your total assets (including the death benefit of your policy) will be less than the threshold, then you wouldn’t need to worry about estate tax in the first place.

* Permanent life insurance has a number of excellent benefits – including these unique tax advantages. However, it can be a complex topic, and you should always consult with a qualified advisor and a tax attorney before making any changes to your current situation.

For a free, no-obligation session with one of our life insurance planning specialists to see how you can take advantage of some of these benefits, contact us anytime!


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