Most people who have purchased a life insurance policy did so because they wanted to protect their family in the future. But while a life insurance policy can certainly be considered a source of security against the future unknown, it is also important to recognize that the policy itself is a type of financial asset.
When you are evaluating the objective value of any financial asset, there are a few important variables you need to consider:
• How much money do I need to surrender in the present?
• How much can I expect to receive in the future?
• What is the timeline in which this growth is taking place?
• What are the taxes associated with this asset?
Life insurance is a unique type of financial asset because the future cash flow schedule is directly determined by the length of your life. This makes it almost impossible to know the true value of a life insurance policy the day that you buy it, though many people consider the security it provides to be truly invaluable.
The relationship between life insurance and taxes is something you can predict much more effectively than you can predict the future cash flows of your policy. We take a look at some of the most commonly asked tax-related questions in the life insurance industry.
Are my Life Insurance Premiums Tax Deductible?
In the United States, there are many things that are currently considered tax deductible. When something is tax deductible that means you can subtract it from your total taxable income for the year. Ultimately, tax deductions help you pay a lower amount of taxes.
Unfortunately, the IRS has decided that life insurance premiums are not tax deductible. They are treated as a personal expense and will not have an effect on the amount of money you owe to the government.
Are the Benefits of My Life Insurance Policy Taxable?
When the benefits of your life insurance policy are given to your beneficiary, they will (almost always) not be subject to income taxes.
However, there are a few exceptions. If your beneficiary, for whatever reason, chooses to receive the benefits of the policy not as a lump sum—but over time—they may end up being required to pay taxes. Whether this situation actually ever comes to fruition will depend on a variety of different factors including their income, the specific characteristics of the policy, and numerous others.
Are Life Insurance Policies That Are Paid to an Estate Subject to an Estate Tax?
Despite the similarities that exist between a life insurance policy and an estate (inheritance), the benefits of life insurance have generally been able to avoid many of the taxes an estate is typically subject to. However, if you have decided to make your estate—rather than an individual(s)—the beneficiary of your policy, things can be a little more complicated.
There are two main circumstances that will cause life insurance given to an estate to be taxed. The first, and most obvious, is a situation in which the deceased has directed a portion of the policy to be used for the explicit purpose of paying estate taxes. The second is a situation in which the deceased’s state of residency has specific rules for this situation.
What Are the Effects of Taxes On a Life Insurance Policy?
Determining the exact impact various taxes have on a life insurance policy can be rather difficult. However, there are a few things that can be immediately observed.
• The fact that life insurance premiums are not tax deductible does not mean they are more expensive in practice than they are on paper.
• If life insurance premiums ever were to be made tax deductible (by Congress), that would be beneficial for life insurance policyholders.
• Benefits from a life insurance policy are treated distinctively different than income. $100,000 in life insurance benefits can be significantly more valuable than $100,000 in ordinary income.
• It is important to know the estate taxes that are specific to your state.
Overall, life insurance can be considered to be more valuable than other financial assets in many different ways. Though there could certainly be some changes made in the current tax code that would benefit policyholders, overall, the current legal climate in the United States should not be a deterrent from investing in a life insurance policy.
Thank you for reading our article, What You Need to Know About Life Insurance and Taxes. If you have any questions, please leave a comment below.