Numerous people purchase life insurance policies for different reasons, such as covering college costs for children or providing cash during retirement. It is crucial that they understand their tax implications when making this purchase decision.
Life insurance proceeds generally aren’t subject to taxes; however, there may be exceptions.
Premiums
Premiums paid to an insurance policy depend on its type and circumstances for whether they’re tax-deductible; individual policies usually aren’t eligible to do this while business owners may be eligible to claim certain deductions; this should be discussed with an expert tax practitioner first.
Most whole life policies offer cash value and death benefits on a tax-deferred basis, meaning your cash value increases over time without becoming taxable unless it exceeds the amount paid in premiums; but be wary not to exceed this limit as exceeding it may lead to tax penalties.
Under current IRS rules, death benefit proceeds of whole life insurance policies don’t have to be subject to taxes if all requirements have been fulfilled by designating your beneficiary, being alive when their death benefit arrives and not claiming it as a deduction in any other tax period. Assuming these criteria have been fulfilled successfully, typically no taxes need be withheld on such benefits if naming yourself as the beneficiary of life insurance policy.
If you own a permanent life insurance policy issued by a mutual life insurance company, you may receive dividends that are non-taxable as long as they do not surpass what was paid in premiums. However, should you withdraw money from or borrow against your life policy, any amounts received beyond its cost basis are subject to taxes and must be reported.
Lastly, if you sell your life insurance policy to another party for a lump sum payment known as “life settlement,” any excess over what has been paid in premiums must also be taxed as this transaction falls under federal and state regulation. This type of transaction typically benefits terminally ill policyholders.
Cash Value
Many whole life policies accumulate a cash value, similar to an investment account. Policy owners can access this money in various ways such as taking out loans or withdrawing it outright; however, doing so could affect death benefits and incur fees or taxes depending on how it’s accessed.
Cash values of life insurance policies typically remain tax-free as long as their cash value doesn’t surpass their “cost basis,” or total amount paid into policy minus withdrawals and dividends. You can borrow against your life insurance’s cash value without incurring taxes; as long as loans are repaid promptly; outstanding loans could reduce death benefits otherwise.
Life insurance provides more tax advantages than just income-tax-free death benefits, including potential capital gains tax-free exchanges via 1035 exchanges. Before considering such an exchange option, please consult a financial expert first.
While life insurance offers you death benefits, its cash value can also be accessed during your life by borrowing against it or making partial withdrawals – however this could have adverse repercussions for beneficiaries and could even cause the policy to lapse.
Once again, life settlement brokers offer another method for cashing out life insurance policies. Selling them is a good choice if you require a lump sum of money to pay off debts or fund retirement; just be sure that when selecting one that you fully understand all associated taxes, fees, and penalties involved with this transaction.
Robin purchased her life insurance policy when she was 32 in order to provide for her family after her death, and is now looking at using its cash value as part of her retirement income supplement. To do this, she can borrow against it without incurring immediate taxes or surrender charges; any outstanding loan balance will simply be deducted from her death benefit amount.
Death Benefits
Life insurance death benefits are typically non-taxable; however, in certain situations they may incur taxes. Furthermore, how beneficiaries access them could have implications on taxes.
Once an owner of a permanent policy passes away, their death benefit is distributed to their beneficiaries or beneficiaries. While no taxes are due on this initial payout amount, any interest accrued during his/her lifetime may be taxed and should be considered separately by beneficiaries.
As an example, if a permanent life insurance policyholder named their estate as beneficiary and died with debts and assets exceeding certain thresholds, federal and state income taxes may become payable on any amount exceeding those thresholds. It would therefore be wise for beneficiaries to consult a financial advisor or tax professional before making decisions about how best to use any death benefit payout.
Taxing death benefits of life insurance policies is another possibility if their owner takes out a loan against it. The IRS levies taxes on any amounts exceeding a policyholder’s cost basis (i.e. premium payments + dividends); in this instance it would be equal to any difference between loan amount and death benefit paid out when someone dies.
Beneficiaries who choose to retain the death benefit payout of their life insurance policy have two options for handling it – taking either a lump sum payment or converting it to an annuity with payments over an agreed-upon time or lifetime period. Each option comes with its own set of advantages and disadvantages; therefore it’s wise to consult a Northwestern Mutual financial advisor and tax professional when making decisions that could affect you directly.
One effective strategy to reduce taxes on life insurance death benefits is naming someone else as beneficiary. By doing so, you can separate incidents of ownership from your estate while also avoiding paying income tax on any interest earned on these death benefits.
Surrendering the Policy
If the policyholder no longer needs or wishes to continue paying premiums, they may opt for surrender. This process cancels their policy and awards a lump sum based on cash value less surrender charges; this amount will still be taxed as it represents investment earnings and part of their death benefit.
Whole and universal life policies build cash value over time that the insurance company invests on behalf of policyholders. Over time, this cash value may increase due to interest credited back into an account and dividend payments made. Although investments made with whole life or universal life policies are taxed as income, usually their taxable amount falls less than total cost basis (the total number of premium payments paid into them).
As soon as you surrender a permanent life insurance policy, its contract with your provider has been voided and they no longer owe any death benefits to you. When this occurs, you will receive its surrender value via check or direct deposit – usually less than the total premiums paid due to fees and charges involved with cancelling it.
As much as there may be multiple reasons a person might consider surrendering their policy, it should only ever be done as a last resort. Some common ones for doing this include:
No Longer Need Coverage: As children become financially independent and no longer require life insurance coverage for them when the policyholder passes, life insurance premiums no longer provide much needed financial security when the time comes. Surrendering this policy enables policyholders to use those funds instead for other financial goals instead.
Decisions concerning life insurance surrender should be carefully considered with help from financial professionals. While surrendering may offer numerous advantages, keep in mind that you no longer have coverage and your beneficiaries will no longer be protected by their existing plan. It would also be wise to explore alternative providers before choosing another policy to replace it with.
