In general, you need to be concerned about taxes during three stages of your policy—whether you are seeking a deduction or wondering about giving a percentage to the IRS. Those major life insurance tax areas include premiums, cash value, and death benefits.
It’s very possible that not all of these three phases will apply to your policy situation, but if you ever plan to switch over from term to whole, they could interest you. More than that, some give up the accumulation of cash value before maturity, meaning certain tax implications won’t apply either.
Explore the following sections to see how taxes relate to your life insurance policy. You’ll see if you can write off your premiums and if you need to pay on the benefits of your policy because of their structure or payment type.
Premiums
The first thing to know about life insurance in relation to taxes is that a policy is considered an asset. For that reason, your contributions through premiums are a regular expense that isn’t typically tax-deductible. Other forms of insurance and expenses can be written off, but your life insurance premiums aren’t included.
Some policyholders will structure their life insurance within a 401k, a tax-qualified plan that has a special tax status. Premium payments to that account can be deducted, but setting up this structure can be impractical and comes with limitations. For example, the policy can’t be worth even 50% of the total 401k holdings, and when the plan gives taxable gains, the tax bill still comes.
This is not standardly done with term-based life insurance policies either because the advantage is so small. To make a 401k to hold the policy, the difference between the level premium cost and the one-year term premium is negligible. Instead, most stick to the standard strategy of giving tax-free benefits on their term policies to be discussed.
Cash Value
Whole life insurance policies can build up value on a tax-deferred basis under IRS Code 7702. In practice, guaranteed cash value and their dividends deposited can be collected and grown without any immediate taxes. Of course, once the amounts are withdrawn from the policy, there is taxation because it is considered regular income due to its similarity to investment income.
Still, there are methods to avoid taxes on cash value policies. One strategy is to loan the remaining amount (without lapsing the entire policy) since, as a personal-use loan, this won’t be taxed. At the same time, this could affect the value of the policy and the dividends it receives—depending on the insurance company and specific policy you have. For instance, the insurance company could change your dividend interest rate because a loan was taken from the policy.
An additional way you might see taxes on your withdrawals is a Modified Endowment Contract (MEC). While all amounts are taxed immediately upon withdrawal, the basis becomes tax-free after all gains are received. In this structure, cash values only grow with a tax-deferred status, but distributions (like those already mentioned) introduce tax rates. In particular, any benefits taken before age 59 and one-half receive a 10 percent penalty.
Death Benefits
Death benefits, it might relieve you to know, are largely not taxable by IRS codes. There are very few situations in which life insurance death benefit payouts need to be taxed when they go directly to the beneficiaries upon completion of the policy. Beneficiaries won’t pay taxes on payouts as they grieve, and nothing will be deducted from your earnest efforts to give them support after your passing through an income. This rule applies to all policies including term, whole, and universal life insurance.
However, there are a few important exceptions to be aware of before you follow this rule. The first is when the person who holds the policy, the insured, and the beneficiary are all different people. With the three-person structure, the policy can be subject to a hefty gift tax if it is above the tax-free gift limits set out by the IRS each year. For this reason, making sure that the owner is the insured keeps the policy proceeds free of taxes.
Other exceptions include policies that are part of a retirement plan and those that are owned and controlled by an estate. Both of these can introduce taxes by gaining interest like an investment and by contributing to a large estate in the eyes of the state where you live or the federal government.
Stay Tax-Free with Policies from Sproutt
Life insurance is a complex business, and it’s almost as complicated as the ways the IRS and state regulators may attempt to tax gifts to your beneficiaries. You can keep the death benefits and proceeds of your life insurance tax-free, tax-deferred, and tax-limited with policies from an expert broker.
Explore life insurance from Sproutt, and design a policy that benefits you as much as your family without losing income unnecessarily to taxation.