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Muddy Waters? - Tax Planning and Life Insurance

The IRS and your Life Insurance

The first thing to consider about life insurance policies and taxes, is that for federal tax purposes, to be considered a life insurance contract AND qualify for favorable tax treatment it must do two things: 1) meet state law requirements and 2) satisfy the IRS’s statutory definitions of what a life insurance policy is.

The IRS looks at several elements of the policy to verify that a life insurance policy is NOT really an investment vehicle; for example; the type of policy, date of issue, amount of the death benefit, and the premiums paid.

Premiums are not tax deductible. Many people think that life insurance premiums are deductible. However, because life insurance is considered a personal expense, you cannot deduct the premiums you pay for life insurance on your tax return.

Employer-paid life insurance may have a tax cost. The premium cost for the first $50,000 of life insurance coverage provided under an employer-provided group term life insurance plan does not have to be reported as income and is not taxed to you. However, amounts in excess of $50,000 paid for by your employer will trigger taxable income for the “economic value” of the coverage provided to you.

Are your premiums paid with pre- or after-tax dollars? Typically premiums are paid after-tax if you buy a life insurance policy on your own or through your employer. However, different rules apply if your company offers the option to purchase life insurance through a qualified retirement plan and you make pretax contributions.

Although pretax contributions offer certain income tax advantages, one tradeoff is that you’ll be required to pay a small tax on the economic value of the “pure life insurance” in the policy (i.e., the difference between the cash value and the death benefit) each year. Also, at death, the amount of the policy cash value that is paid as part of the death benefit is taxable income. This option to purchase life insurance through a qualified retirement plan isn’t offered by most companies these days, however.

Your beneficiary probably won’t have to pay income tax on the death benefit received. Whoever receives the death benefit from your insurance policy usually does not have to pay federal or state income tax on those proceeds. This is generally true regardless of whether you paid all of the premiums yourself, or whether your employer subsidized part or all of the premiums under a group term insurance plan.

Different income tax rules may apply if the death benefit is paid in installments instead of as a lump sum. The interest portion (if any) of each installment is generally treated as taxable to the beneficiary at ordinary income rates, while the principal portion is tax free.

In some cases, insurance proceeds may be included in your taxable estate. Be aware that if you hold the right to change the beneficiary, the right to take out policy loans, and/or the right to surrender the policy for cash at the time of your death, the proceeds from that insurance policy will be included in your taxable estate. Furthermore, if you gift away an insurance policy within three years of your death, the proceeds from that policy will be pulled back into your taxable estate. To avoid having the policy included in your taxable estate, someone other than you should be the owner.

Note: If the owner, the insured, and the beneficiary are three different people, the payment of death benefit proceeds from a life insurance policy to the beneficiary may result in an unintended taxable gift from the owner to the beneficiary.

A cash value component will grow tax deferred. Permanent life insurance as opposed to term life policies, have a cash value that grows year after year, tax deferred. As the cash value grows, you may ultimately have more money in cash value than you paid in premiums. If you make a withdrawal from the policy, sell or surrender it, the growth amount, will be taxed as ordinary income.

Dividends are usually tax-free. Policies known as, “participating policies” usually pay dividends. An insurance dividend is the amount of premium that is paid back to you if the insurance company achieves lower mortality and expense costs than expected.

Regardless of whether you receive the dividends in cash, leave them on deposit, or buy additional life insurance within the policy, they are considered a return of premiums. If you leave the dividends on deposit and earn interest on them, or receive more than you paid in, the amount in excess will be taxable either as interest income or ordinary income.

When are withdrawals taxable? If you withdraw cash from a cash value life insurance policy, the amount of withdrawals up to your basis in the policy will be tax free. Generally, your basis is the amount of premiums you have paid into the policy minus any dividends or withdrawals you have previously received. Withdrawals in excess of your basis will be taxed as ordinary income.

Surrendering your policy may result in a taxable gain. If you surrender your cash value life insurance policy, any gain on the policy will be subject to federal (and possibly state) income tax. The gain on the surrender of the cash value policy is the difference between the gross cash value paid and your basis in the policy.

It is possible to exchange one policy for another without triggering tax liability. The tax code allows you to exchange one life insurance policy for another (or a life insurance policy for an annuity) without triggering current tax liability. This is known as a Section 135 exchange. However, you must follow the IRS’s rules when making the exchange.

These are just a few of the guidelines surrounding life insurance policies and the taxation on them. The rules concerning life insurance are obviously complex and are subject to change: likewise, your needs change depending on your season of life. Be proactive and use a tool and strategy that accomplishes your goals. For more information, contact us to schedule a review of your tax plan and insurance needs today.

The information in this document is provided by a third party and has been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by DP Financial & Tax, Inc. Adapted from Broadridge Investor Communication Solutions, Inc.


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