Is there tax on life insurance? – You may have wondered to know. Even if you have not, you should.
Don’t credulously believe an agent if he says the policy you are planning to buy is tax-advantaged. While he may not be usually lying to you when he says so, he may not be absolutely right either.
Typically, you do not have to pay taxes for your life insurance proceeds. But there are exceptions. If you are not aware of the exceptions, which themselves are rules, you will end up paying taxes on your proceeds.
Understanding the way there may be tax on life insurance can be a very complicated issue. So, with a view not to confusing you, we have dealt with 6 most essential questions that every buyer should know the answers to.
Question 1: Is There Tax on Life Insurance Death Benefit?
General Rule: The answer is – no, absolutely not. A beneficiary to term insurance or whole insurance does not have to pay tax on the death benefit. According to IRS rules, life insurance coverage money does not fall in income category. Instead, it is reimbursement to your lost income. As a result, death benefits of life insurance do not incur income tax.
Exception 1: There is a misinterpretation that when you take out the total benefit at a time, you do not have to pay any taxes. According to this (mis)interpretation, when you take out the benefit in installments, you will have to pay income taxes.
The fact is, the source money that you receive as death benefit never comes under taxation. But any profit or interest that grows on the source money when you leave it with your insurer to invest will come under taxation.
That means, there will be tax on life insurance benefit when there is any internal gain on your term life insurance plan or whole insurance death benefits.
This happens when you do not take out all your money at a time. Instead, you leave your benefit with the insurer so that the insurer provides you interest. This interest is considered income and taxable.
Exception 2: Again, life insurance death benefits come under taxation when it becomes part of your estate. It so happens when you retain rights over your insurance plan. For example, if you retain right over your insurance to modify, make changes or take out the cash value, you create what is known as ‘incidence of ownership’. This status will tie you to tax net if the value of your estate crosses the estate tax-exemption limit (around $5.5 million).
Question 2: Do I Have to Pay Tax on Life Insurance Dividend?
General Rule: Participating life insurance, aka, whole life insurance that you buy from a mutual insurance company provides you dividend. This dividend is part of the profit that mutual insurance companies annually share with you as a stakeholder of the company. This dividend is considered return of premium (not to be confused with term plan known as Return of Premium insurance), not income. As a result, you do not have to pay any income tax on the dividend you receive.
Exception: When your dividend stays with the insurer and goes into bringing profit, the profit part will have income tax imposed on it. However, it so happens only when the interest on the dividends crosses your original payment. On the other hand, when your dividend works in the default way, i.e. goes toward the building of the coverage, you will have not tax imposed on it.
Question 3: Is There Tax on Life Insurance Endowment?
General Rule: Endowment life insurance is something that you buy for receiving a lump sum of money after a certain period. After the typical 10 or 20 years has passed, you receive the full coverage of money mentioned in the contract. If you happen to die before the maturity period, the full coverage goes to your heirs. The proceeds that thus you receive from an endowment insurance do come to you tax-free.
Exception: Endowment insurance provides a guaranteed benefit. If the benefit crosses the guaranteed amount, the extra money will have taxes on it.
Question 4: Is There Tax on Life Insurance Maturity Benefit of Whole Insurance?
General Rule: There are still some whole life plan holders whose policies will mature when they are 95 or 100 years old. If they outlive the policy, they will receive cash value or maturity value. The minimum guaranteed coverage of these policyholders will not have tax on it.
Exception: Anything extra that they receive beyond the coverage in contract is to have income tax on it.
Question 5: Is There Tax on Life Insurance When I Surrender?
General Rule: When you surrender your cash value life insurance it will not incur tax so long as it does not show you have had income from it. That is if your net withdrawal on surrender value is below or equal to whatever amount you paid for the policy, there will be no income tax.
Exception: The exception here is the opposite of what happens to you when the general rule applies. If the amount goes beyond what you have paid up, the extra amount will have tax on it.
Question 6: Is There Tax on Life Insurance When I Sell It to Someone?
General Rule: If you happen to have to sell your insurance, the ownership naturally needs to be changed in favor of the buyer. The buyer collects the benefit when you die or when the policy matures. If the buyer is someone who can lay claim in the policy benefit, he is an insurable party with you. If the buyer is such a person, the benefit will not have tax on it.
Exception: When you transfer the ownership of your life insurance policy to someone who is not a person with insurable interest with you, the tax exemption rule will not apply. That means when you die, the buyer will have to pay income tax on the benefit.
It is remarkable that while the tax rules apply mostly to internal gains of a policy, the income tax will be on the gross benefit that the buyer receives.
We have already said tax on life insurance can be a very complicated issue. The 6 questions we have brought up here for discussion are the ones most consumers find answers to. It is important that you discuss the issue with some lawyer when you buy insurance.