Life Insurance & Taxes

The concept of life insurance is steeped in taxation issues. For term life policyholders, the most pressing tax question concerns their beneficiaries: will the death benefit of the policy be received tax-free? For whole life policyholders, the tax issues become even more complex. Because these policies accumulate cash value over time, questions of taxation arise for both policyholders and beneficiaries of whole life coverage. In addition, concerns about estate taxes may affect both term and whole life policyholders. Clearly, life insurance holds a bevy of tax dilemmas, and we will offer advice on grappling with these issues in what follows.

Income Tax
For the most part, the death benefit of life insurance policies is received free of income tax. Section 101 of the IRS code stipulates that the proceeds of a life insurance policy resulting in a death claim are not subject to income tax when paid, subject to certain exceptions. The favorable tax treatment of life insurance is one of the reasons the industry has grown like it has.
Estate Tax
The estate tax is one potential pitfall policyholders must take into account if they wish to avoid taxation on their life insurance policy. If you die as the owner of your life insurance policy, the proceeds of the policy are applied toward your taxable estate. However, as of 2009, your estate will not be subject to federal taxes if it is worth less than $3.5 million. Similarly, if your estate goes to your spouse, it will also be exempt from estate tax. On the other hand, the value of your life insurance policy will be added to the value of your taxable estate if you do not transfer ownership to a third party. You can do this by setting up an irrevocable trust for your children, for example, or other beneficiaries. Your policy will also be subject to estate taxes if you die within three years of transferring ownership.
Tax-Deferred Investment
Whole life policyholders not only have to worry about the taxation of their policies after they die, but also while they are still alive. Whole life policies are essentially tax-deferred investments, which means you only pay federal income tax when you take money out of the investment. As long as they remain invested, the earnings your investment yields are also tax-deferred. Tax-deferred treatment is extremely valuable because all of your money is reinvested rather than being taken out to pay taxes. As a result, you have more money in your investment to compound and grow. Additionally, if you are investing in a whole life policy for retirement purposes, you will likely be in a lower income-tax bracket at retirement age than you are now. In other words, you will pay fewer taxes on the money when you finally withdraw it because of its tax-deferred status.
If you would like to avoid taxes altogether on a whole life policy, the key is to structure the withdrawals you make as loans on the policy. Loans against whole life policies receive preferential tax treatment. For example, once you reach age 65, you could make tax-free withdrawals as policy loans for twenty years or more to supplement your retirement income. Even after the withdrawals, your policy would still have a substantial death benefit, and you would have enjoyed tax-free retirement income for several decades.