Life insurance is a financial product that pays a lump sum in the event of the insured person's death and provides financial support to beneficiaries and heirs. It's important to consider the tax implications when buying life insurance, as the Internal Revenue Service (IRS) imposes different tax rules on different plans. This guide aims to help explain some of the tax implications surrounding life insurance premiums. A person looking for life insurance has many things to consider before making a decision.
First, there is the distinction between term life insurance and comprehensive life insurance. A term life insurance policy provides coverage for a specified number of years, while a lifetime policy is effective for life. The policyholder must also calculate the coverage they need, which largely depends on why they're buying life insurance. Unlike buying a car or television, buying life insurance doesn't require paying sales tax.
Some life insurance plans allow the policyholder to pay a global premium in advance. That money applies to plan premiums for the entire duration of the plan. The lump sum payment also increases in value due to interest. The IRS considers the growth of that money to be interest income, which means that it may be taxable when applied to the payment of a premium or when the policyholder withdraws part or all of the money he has earned. Life insurance premiums that the IRS classifies as personal expenses cannot be deducted on your federal tax return.
Many full life insurance plans, in addition to providing the insured with a fixed death benefit, also accumulate cash value as policyholders pay the plans with the money from their premiums. A portion of the premium dollars goes to a fund that accumulates interest. It's common, especially in plans that have been in place for many years, for the cash value to exceed the amount the policyholder has paid in premiums. People use this type of life insurance as an investment vehicle, in addition to taking advantage of the protection it provides to their families in the event of an untimely death.
Tax-Deferred Cash Value Accumulation
The good news for the holder of a lifetime policy is that they don't have to pay income taxes every year because of the increase in the cash value of their plan.As with retirement accounts, such as 401 (k) plans and IRAs, the accumulation of cash value in a full life insurance policy is tax-deferred. Although this money is considered income for the insured, it has income tax implications.
Loans Against Life Insurance Policies
The proceeds of loans taken against full life insurance policies are not taxable, even when the loan amount exceeds the total premiums paid on the policy. Applying for a loan reduces the value of the policy's death benefit until it is repaid (along with the interest due).Death Benefit Tax Implications
Life insurance provides beneficiaries with the death benefit free of income tax. However, you may be subject to wealth tax if the combined value of the estate, including the death benefit, exceeds the tax threshold.Conclusion
Life insurance premiums are generally not subject to sales tax and are not tax-deductible in most cases.However, there are certain circumstances in which you may face certain tax consequences when dealing with life insurance premiums. Be sure to consult your tax advisor about your particular situation and make sure you understand all of your options before making any decisions.
