Life insurance proceeds may be tax-free, depending on what proceeds you or your beneficiaries receive. Life insurance protects your family from your financial debts and obligations after you die by providing a death benefit, but it also may be used for business purposes to compensate a company for the loss of a key person in the company. In all of these cases, life insurance provides some tax benefits, but also comes with some tax liabilities.
Life insurance is generally received income tax free. The death benefit is income tax free when the insured individual dies. If the policy has a cash reserve, called a cash value, the cash value is generally tax free as well. A cash value functions as a savings that may be using during the policyholder's (the owner of the life insurance policy) lifetime. The cash value may be withdrawn from some policies, while all cash value policies provide provisions for loans against the policy's cash value. If the policy lapses (terminates), all policy loans are treated as income and the remaining cash value in the policy is paid out to the policyholder and treated as income. Any amount of money received that exceeds the total amount of money paid into the policy is considered a gain in the policy and subject to ordinary income tax.
The estate tax does not apply directly to life insurance. However, the death benefit is included in the calculation for estate taxes. This means that if an insured individual dies, the death benefit of his policy is added to the value of the rest of his estate. If the estate value exceeds the total amount excluded from estate taxes, then estate tax will be due on the value of the estate. While the proceeds of the policy do not need to be used to pay for this tax, it may be necessary as a practical matter, especially if the beneficiaries are related to the insured individual.
To prevent income tax issues due to a policy lapse, you should make sure that you pay back any policy loans you take out against your life insurance policy. This will ensure that the policy does not lapse due to excessive loan activity and trigger income tax due on cash values. Additionally, you must transfer your life insurance policy into a life insurance trust if you want to avoid the death benefit from being included in the calculation of estate taxes.
Before you take out a life insurance policy, make sure that you can make a commitment to paying the premiums on the policy for the life of the policy. Generally, this means that you have a stable source of income and a way to temporarily pay premiums if you lose your job. You should also analyze your need for a life insurance trust as you get older and accumulate more assets.
- "Life Insurance"; Kenneth Black, Jr., Harold D. Skipper, Jr.; 1994
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004