Life insurance policies are financial products that provide a death benefit in exchange for premium payments. This death benefit provides money to your beneficiaries for any purpose they choose. Life insurance also offers some exemptions from income tax. However, these exemptions depend on how you use the life insurance policy, so you should be aware of when a policy is and is not subject to income tax.
Term life insurance is not subject to income tax. This is because the death benefit of the policy is passed to your beneficiary income tax-free. Permanent life insurance, like whole life and universal life insurance, provides tax-free death benefits as well, but these policies also build a cash value savings that might be subject to income tax under certain circumstances.
Cash value, or permanent, life insurance builds a cash reserve, called a cash value, that is associated with the policy's death benefit. The cash value is tax-free as long as money is inside of the policy and not used. If the cash value is withdrawn from the policy, the money is tax-free as long as you do not withdraw money in excess of the total premiums you've paid into the policy. The total premiums you pay into the policy is referred to as your "basis." You may also take a loan against your policy up to the amount of available cash value in the policy. If you do, then the policy loan is tax-free.
Regardless of whether you make withdrawals or policy loans, if you terminate the policy, any gains in the policy are taxed as income. All policy loans are "forgiven" and treated as income. A gain is considered to be any amount in excess of your basis in the policy.
The benefit of life insurance is that your beneficiaries don't pay income tax on any of the death benefit proceeds, regardless of whether the policy is a term or permanent life insurance policy. The benefit of a life insurance policy during your lifetime is if you purchase a permanent life insurance policy. You get the benefit of using a tax-free savings (the cash value) during your lifetime.
The disadvantage to life insurance is that, if you own a permanent policy, you must keep the policy in force to avoid paying income tax on the cash value. This may become difficult if you borrow from the policy regularly. Many life insurance companies charge interest on life insurance policy loans to the policy's cash value.
Policy loans are loans against the value of the life insurance policy's cash value, similar to how home equity loans and mortgages are loans against the value of a home. With a life insurance policy loan, however, interest on that loan is normally paid out of the remaining cash value (charged to the cash value) when you die. Because policy loans do not have to be repaid during your lifetime, the interest is considered to be "accumulating" in the policy until your death, which may cause the remaining available cash value to decrease over time. The loans, plus interest, must be repaid at your death. When there is no more cash value available to borrow against, the policy lapses (terminates).
If your policy lapses, you'll have to pay income tax on all of your gains of the policy. If your policy lapses when you're older, you may not have the money available to pay the tax due and you may be liable for income tax and penalties to the IRS.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A. Crane; 2007
- "Life Insurance"; Kenneth Black, Jr., Harold D. Skipper, Jr.; 1994
- "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004