Insurance is one thing, but the tax regulations are entirely another. As insurance products have progressed and continue to become more complex over time, the distinction between insurance and investment vehicles has become increasingly blurred. To distinguish between the two, a blend of intricate regulations and exemptions now governs the taxation of insurance products. If you lack the time to decipher the IRS guidelines, here are some pointers and details regarding life insurance taxes to assist you in comprehending the matter.
Life insurance contracts must adhere to IRS requirements
To qualify for favorable tax treatment, an insurance contract must meet both state law requirements and the IRS’s statutory definitions of a life insurance policy. The IRS examines factors such as policy type, issue date, death benefit amount, and premiums paid. These definitions act as tests to ensure that an insurance policy is not an investment vehicle. It is the responsibility of the insurance company to comply with these rules and enforce the provisions.
Note that you cannot deduct life insurance premiums from your federal income tax return since they are considered personal expenses.
Life insurance paid by an employer may have a tax cost
Potential tax implications of employer-paid life insurance The premium cost of the initial $50,000 coverage under an employer-provided group term life insurance plan is not taxable and does not have to be reported as income. However, any amounts exceeding $50,000, which are paid by the employer, will result in taxable income for the “economic value” of the coverage provided.
Determine whether your premiums were paid with pre-tax or after-tax dollars
Determining the tax status of your insurance premiums The taxation of life insurance proceeds depends on various factors, including whether your premiums were paid with pre- or after-tax dollars. If you acquire a life insurance policy individually or through your employer, it is likely that your premiums are paid with after-tax dollars.
Different rules may apply if your company offers the option to purchase life insurance through a qualified retirement plan and you make pretax contributions. While pretax contributions offer certain income tax advantages, you will be required to pay a small tax each year on the economic value of the “pure life insurance” in the policy. Additionally, upon death, the cash value portion of the policy paid as part of the death benefit is considered taxable income. However, it is rare for companies to provide the option of purchasing life insurance through a qualified retirement plan.
The beneficiary of your life insurance policy probably won’t incur income tax on the benefit they receive
Income tax on death benefit received by your life insurance beneficiary is usually not required Generally, the death benefit received by the beneficiary of your insurance policy does not incur federal or state income tax. If you pass away with a life insurance policy having a $500,000 death benefit, the beneficiary will generally not have to pay income tax on the $500,000, irrespective of whether you paid all the premiums or if your employer subsidized them under a group term insurance plan.
Different income tax rules may apply if the death benefit is paid in installments instead of a lump sum. The interest portion of each installment is typically taxable to the beneficiary as ordinary income, while the principal portion remains tax-free.
Proceeds may sometimes be included in your taxable estate, pay attention!
Possible inclusion of insurance proceeds in your taxable estate may exist if you possess any incidents of ownership in an insurance policy at the time of your death. The proceeds from that policy will be included in your taxable estate if you hold any of these ‘incidents of ownership,’ including the ability to change beneficiaries, take out policy loans, or surrender the policy for cash. Additionally, if you gift an insurance policy within three years of your death, the proceeds will be brought back into your taxable estate. To prevent the policy from being included in that, someone other than yourself, such as a beneficiary or a trust, should be the owner.
See, if the owner, the insured, and the beneficiary are different individuals, the payment of death benefit proceeds from a life insurance policy to the beneficiary may inadvertently result in a taxable gift from the owner to the beneficiary.
You probably won’t have to pay taxes on loans taken against your policy
If you take out a loan against the cash value of your insurance policy, the amount of the loan is not taxable (except in the case of an MEC). This result is the case even if the loan is larger than the amount of the premiums you have paid in. Such a loan is not taxed as long as the policy is in force. If you take out a loan against your policy, the death benefit and cash value of the policy will be reduced.
You can’t deduct interest you’ve paid on policy loans
The interest you pay on any loans taken out against the cash value of your life insurance is not tax deductible. Certain loans on business-owned policies are an exception to this rule.
The surrender of your policy may result in 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 a cash value policy is the difference between the gross cash value paid out (plus any loans outstanding) and your basis in the policy. Your basis is the total premiums that you paid in cash, minus any policy dividends and tax-free withdrawals that you made.
You may be able 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 1035 exchange. However, you must follow the IRS’s rules when making the exchange.
Important Disclosures: The tax rules surrounding life insurance are obviously complex and are subject to change. For more information, contact a qualified insurance professional, attorney, or accountant. This article was prepared by InVestra Financial Services for the use of InVestra Financial Services. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested directly. The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal professional.
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