There’s an old saying that the only things we can be certain of in life are death and taxes. While this doesn’t sound pleasant, people generally accept the inevitability of both. Yet, ironically, aside from their inevitable certainty, there is another more positive connection these two events share – and that’s life insurance. Yep, you read right!
- Death Benefits. The first question most people ask is, are life insurance benefits taxable? The short answer is no. When a policyholder passes, the beneficiaries receive the death benefit free of income taxes. That’s because the IRS considers the death benefit as a reimbursement for a loss rather than income – a small sigh of relief during the most difficult times.
- Tax-deferred growth. When you pay your life insurance premiums on a permanent policy, the insurance company invests that money. Over time, those investments increase, and the policy may build cash value. As long as those gains remain inside the policy, they will continue to compound year after year with the potential for significant earnings. Once the policy is surrendered or lapses, only then are the gains taxed.
- Dividends. Mutual insurance companies, which are owned by policyholders, often pay annual dividends. Because the IRS sees these dividends as a return of your premium rather than income, you do not have to pay income taxes on your dividends. Alas, there is one caveat: if the dividends you get paid in any year exceed your premiums, then you may need to pay taxes on the difference.
- Wealth transfer. The estate tax is perennially one of the hot-button political issues every election cycle. So you’re likely aware if your estate is valued over a certain threshold, your heirs have to fork over a hefty chunk to the IRS once they inherit it. But, as mentioned earlier, death benefits are not subject to income taxes in most cases, whether $100,000 or $10,000,000. So, life insurance can be a pretty smart way to transfer money to the next generation tax-free. Note that there are some exceptions to this rule, so check with your financial advisor or tax professional if you have any questions.
- Withdrawals and loans. Finding you’re running short on cash? Good news. You may be able to withdraw funds from your life insurance policy up to the amount you’ve paid in premiums without paying taxes on that money. That’s because the money you’re withdrawing is simply a return of the premiums you already paid, so the IRS doesn’t consider it income.
Another way to take money out of your permanent life insurance policy is by borrowing against its cash value. As long as you pay the money back, you won’t pay income taxes. It’s important to note, too, that if you take a “surrender payout” on your life insurance policy, you won’t pay income taxes on the premiums paid – just any profit that was realized – but that’s true of any investment.
- Exchanging for an annuity. One of the least known – and perhaps most valuable – advantages of permanent life insurance is having the ability to exchange the entire cash value of the policy for an annuity, with no taxes on the gains. An annuity is a contract between an individual and an insurance company where the insurance company pays the individual an annual income for the rest of the individual’s life in exchange for a specified payment upfront. If this sounds like it fits in with your family’s financial situation, it may not be a bad deal.
- Retirement income. Because of all the ways people can take money from permanent life insurance policies – and the tax advantages – many retirees often use the cash value to fill in any income gaps they may encounter. They can withdraw cash or take a policy loan without worrying about income taxes or required minimum distribution rules as with traditional IRAs.
Please note that the information provided is not intended to be a recommendation. It is for general information, but where required or depending on your personal circumstances, you should always seek professional guidance.