Life Insurance Taxes – What You Need To Know

What are the rules you need to know when it comes to life insurance taxes?  When it comes to taxes, there are many different rules and laws that you must follow based on your unique financial situation.  Please be sure to refer to your tax professional when calculating your own taxes annually.  However, this is a good overview of what you should expect when you are dealing with life insurance taxes in varying roles. 

Term Life Insurance Taxes

Term life insurance is a form of temporary life insurance. This type of life insurance covers the insured for a specified period of time – often 10, 20, 0r 30 years of their life.  During this period as long as the premiums are paid on time the listed beneficiaries on the policy are entitled to the death benefit if the insured were to pass away during the specified time frame.  If the listed beneficiary or beneficiaries are individuals, they will not be taxed on the amount they receive from the death benefit as long as its under the estate tax threshold. In 2022,  the Estate Tax Exemption for an individual is $12.06 million and $24.12 for a married couple. Therefore, if the combined assets of the estate falls under those limits there will not be taxes for the beneficiaries from the death benefit of the term life insurance policies.  Term life insurance taxes are less complicated than permanent life insurance taxes because of the lack of a cash value to the policy.

Permanent Life Insurance

Permanent life insurance is a form of life insurance that is built to last your entire life and has a cash value component to it.  There are three main type of permanent life insurance – universal life insurance, variable life insurance, and whole life insurance. The major differentiator between the three types of permanent life insurance is how the cash value of the life insurance policy is invested.   Whole life policies have the cash value grow according to a formula that the insurance company determines.  Universal life insurance policies normally have the cash value grow based on current interest rates.  Variable life insurance policies have the cash value invested in different subaccounts that insured can pick where the cash value is invested in and the cash value grows (or declines) based on the performance of those subaccounts.

In each of the three main types of polices above (whole, universal, and variable) the cash value grows tax deferred.  This means that the cash value will not be taxed while its growing and therefore your cash value will grow faster than if it wasn’t taxed deferred.  This is because the interest or growth is applied to a higher amount. So, are there permanent life insurance taxes that you should be aware of? Yes, there are!  Similar to term life insurance, if the inheritance exceeds the Estate Tax Exemption, a portion or all of the death benefit may be taxable. 

Surrendering Your Policy

Additionally, since there is a cash value element to permanent life insurance contracts you have the option to surrender or cash in your policy.  This means that you are giving up the death benefit of the life insurance policy and you would be receiving the cash value of the policy less any surrender charges if there are any.  However,  this may be a taxable event in certain circumstances.  The total of premiums you have paid into the policy is known as the cash basis. When you surrender a policy, the amount of the cash basis is considered a tax-free return of principal. Only the amount you receive over the cash basis will be taxed as regular income, at your top tax rate. For example, if you paid a total of $10,000 in premiums over 15 years and the cash value at the time you surrendered your policy is $15,000 you would owe taxes on $5,000 of the $15,000 you received from the policy.  This amount is going to be taxed at your ordinary income tax rate whatever that might be.

Loans on Life Insurance Policies

Another life insurance tax benefit kicks in if you decide to borrow against your cash value. Although this type of loan isn’t treated as taxable income, it will have interest charged by the insurance company until you pay it back, and each insurance company has its own rates. You can also choose not to pay the loan money back, although this would affect the amount of your life insurance payout to your beneficiaries. There are several approaches to consider when deciding whether to withdraw or borrow from your cash value. It’s important to talk to your financial representative to decide which choice is best for you.

The bad news is loan balances generally reduce your policy’s death benefit, meaning your beneficiaries might receive less than you intended. Also, an unpaid loan that is accruing interest reduces your cash value, which can cause the policy to lapse if insufficient premiums are paid to maintain the death benefit. If the loan is still outstanding when the policy lapses or if you later surrender the insurance, the borrowed amount becomes taxable to the extent the cash value (without reduction for the outstanding loan balance) exceeds your basis in the contract.

ILIT Tax Strategy

Another option for higher net worth individuals is an irrevocable life insurance trust (ILIT) that purchases the insurance policy directly, so as to exclude it from one’s personal estate. You make a cash gift to the ILIT to purchase a permanent survivorship life insurance policy. The ILIT is the owner and beneficiary of the policy. When the survivor dies, your heirs will not have to pay estate and income taxes on the death benefits. This is one way to get out ahead of the previously stated estate tax issue if your total assets might come close to going above the exemption limit.

Any Questions?

If you have any specific tax questions please refer to a tax professional to make sure you know the exact tax ramifications based on your unique financial situation before doing any transactions.  If you are thinking about purchasing life insurance, want more information or want to apply for a life policy, contact NextGen Life Insurance. Get your free quote today or call us at 646-216-4199 to get started.