by Joel Ray
Guest Author/Financial Advisor
Many policyholders worry about the impact of taxes on the death benefit and proceeds of their life insurance plan. Whole life insurance tax benefits typically cover payouts, so your beneficiaries won’t be saddled with taxes. There are some exceptions, however, so let’s look at the tax benefits of whole life insurance in some detail.
When is Life Insurance Not Taxable?
Here’s an overview of the circumstances where permanent life insurance offers tax-free gains:
- Death Benefit Payout – When beneficiaries receive the death benefit from your policy, this sum will almost always be tax-free. The exception is where the payout forms part of your estate, and the combined estate is large enough to incur federal or state taxes.
- Benefit Payout to Spouse – When your spouse is the beneficiary of your insurance policy’s proceeds, the death benefit payouts they receive are non-taxable (even as part of your estate). This is a common method used for tax-free wealth transfers.
- Accumulated Cash Value – Permanent life insurance plans typically build a cash value over time, in addition to providing death benefits to your beneficiaries. These cash value gains are exempt from income tax.
- Cash Value Loans/Withdrawals – When you make a withdrawal against the accumulated cash value of your whole life insurance, the money does not incur taxes or penalties. This is where permanent insurance wins over 401Ks and IRAs!
- Surrendering a Policy – You can opt to give up your permanent life insurance plan in return for a lump sum payment, by agreeing to halt future payouts. As long as this payout (upon surrender) is lower than the total you’ve paid in premiums, it will be tax-free.
- Merging Insurance with Investments – When you combine funds in your permanent life insurance with investments in real estate, auto financing or private lending, you can enjoy significant returns from both the policy and the investment, while money in the policy remains tax-free.
- Mutual Insurance Dividends – Certain insurance companies offer annual dividends from profits made, to policyholders with a share in the company. As with policy “surrender”, these dividends are tax-free if they’re less than the sum total you’ve paid in premiums.
When is Life Insurance Taxable?
Even with tax-free permanent life insurance, there are certain situations where taxes will be involved, like:
- Payouts in Installments – Your policy’s beneficiaries may choose to take payouts in the form of installments instead of a lump sum, and earn interest on the balance in the plan. If they’re earning interest, they will need to pay income tax on it.
- Estate Taxes on Payout – If your policy’s death benefit is part of your estate upon death (you are the owner of the plan when you die), then the proceeds may be subject to estate tax. This happens only if the total value of the estate is taxable.
- Profits from “Surrender” – While surrendering a whole life plan with a cash value, you will be liable for income tax if the accumulated value of the lump sum payout is more than what you’ve paid in premiums.
- Profits from Policy Sale – Life insurance settlements allow you to sell an existing policy to another individual, who will then take over the premium payments and receive the payout after your death. Depending on various factors, this income may be taxed.
- Unpaid Policy Loans – While you can borrow funds against the cash value of your policy, these need to be repaid with interest. If your policy lapses or is surrendered before the loan is paid in full, you will owe taxes on any unpaid amount (over the total value of premiums you’ve paid).
- Non-Refund Life Annuity – If you combine your insurance plan with a non-refund life annuity contract (single premium paid for an equal face value in the plan), payouts over the face value will be taxable (e.g. interest, if beneficiaries choose installments).
Insurance isn’t just for financial security. Wealthy people have been using various life insurance types (like whole or variable life insurance) as tax-free investments, where dividends, payouts and cash value gains are not subject to heavy tax burdens. It’s time you do the same!
Author’s Bio: Joel Ray is an experienced financial advisor and his areas of specialization include retirement planning and risk management. When Joel is not working with clients, he is busy creating informative blogs and whitepapers. Follow this financial whiz @life_centra. You can also check out his fiscal blogs and videos on LifeCentra.