Life insurance is essential for the financial security of your family, providing the funds to cover everything from outstanding medical expenses to mortgage payments in the event of your death. With a huge number of companies offering a variety of life insurance products, it’s advisable to use a life insurance quote tool to find a policy that meets your exact requirements and budgetary needs. It’s also important to consider the financial implications of your insurance policy’s tax benefits in addition to any death benefits. With some careful planning, it’s possible to arrange your life insurance coverage to maximize tax breaks and reduce your family’s financial burdens.
Whole Life vs. Term Life Insurance
Life insurance falls into two main categories: whole (permanent) life insurance and term life insurance. Both products offer distinct advantages.
- Term life insurance provides coverage for a defined period of time and therefore only pays a death benefit if you die prematurely and within the term of the policy. If you outlive the policy, it has no value. These products normally offer terms lasting from 1–30 years, and the annual premiums are low.
- Whole life insurance provides coverage until your death, ensuring a death benefit regardless of how long you live. The premiums are higher, but such products also accrue a cash value over time and offer substantial tax benefits.
Is Life Insurance Taxable?
If you become the owner or beneficiary of a life insurance policy, it’s important to understand the tax responsibilities associated with the policy. One common concern is whether the proceeds from an insurance policy count as income for tax declarations.
In normal circumstances, if your beneficiary receives proceeds from your life insurance policy following your death, the benefits are not included in his or her gross income and therefore don’t have to be reported, according to the IRS. Any interest received is taxable and must be declared.
While proceeds are income tax-free, they may still be part of your taxable estate for estate tax purposes, which means they contribute to the total assets subject to taxation following your death.
Congress has included many tax code provisions to give life insurance important income tax and transfer tax benefits. Such provisions increase a product’s value as a financial security. Understanding how they work makes it easier to choose an insurance product that’s suitable for your family’s needs.
Death benefits are income tax-free unless your beneficiary receives them as an annuity (any interest accrued is taxable), and the beneficiary can take advantage of the full payment to settle outstanding obligations, such as a mortgage, and secure future financial stability. Some life insurance products pay for chronic or terminal illness prior to your death, and those payments are also income tax-free.
Policy Cash Values
Whole life insurance policies accrue cash value over time. This value is tax-deferred, and it’s possible for you to use the sum against a loan or else withdraw it to settle financial obligations. If you surrender your policy before death, you receive the cash value, and only the excess of the value over the amount of premiums you paid is taxable. Withdrawn amounts up to your tax basis, or borrowed amounts exceeding your tax basis while the policy stays in force, are income tax-free.
Some whole life products from mutual insurance companies offer dividends. This is because the company doesn’t have shareholders and instead puts profits back into the hands of the policyholders. There’s a chance you might not receive any or many dividend payments, but they offer a strong incentive to choose a product from a mutual company. The dividends are classed as “return of premium,” so they’re only taxable if they exceed the premiums you paid.
A Section 1035 Exchange involves replacing an existing product without incurring any tax consequences. This makes it possible to replace a product or policy that no longer meets your needs with a more suitable one. The three types of tax-free exchanges are:
- Replacing an annuity with another that has identical annuitants
- Replacing an endowment policy for an annuity or identical endowment policy
- Replacing an insurance policy with another insurance policy, endowment policy or annuity
Note that such exchanges are only tax-free under IRS rules if the contract exchanges directly between the involved insurance companies. If you cash in a policy and then use the proceeds to purchase a new product, you lose the tax-free benefits.
Transfer Tax Benefits
If your beneficiary is a spouse with United States citizenship, the death benefits from your insurance qualify for the marital deduction. If you transfer ownership of your policy to someone else and don’t have any incident of ownership within the three years prior to your death, the death benefits aren’t classed as part of your taxable estate. Any premiums that the policy owner pays aren’t treated as taxable gifts.
Congress has made numerous provisions for life insurance, and owning a policy puts you in a good position to take advantage of various tax benefits. Before committing to a policy, research your options carefully, and consult with a financial advisor to ensure the product you choose offers you the ultimate in financial security and flexibility by minimizing income tax and possible estate tax payments.