How Is a Life Insurance Policy Taxed?
The values of a life insurance policy can be affected by taxation. There are tax benefits that can aid in the accumulation of funds for the death benefit. The IRS, however, has imposed tax consequences that can decrease the amount of money paid out to beneficiaries. There are ways for policy owners to avoid taxation of their policies and provide the most money for their loved ones.
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Life Insurance
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Permanent life insurance policies such as whole life and universal life have a savings component called a cash value account. A life insurance policy earns value over time by the investment performance and the return rate given by the insurer. The money is credited into the account. The cash value account is tax-deferred, which means that the money will grow tax-free until it is withdrawn.
Benefits
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Permanent life insurance policies such as whole life and universal life have a savings component called a cash value account. A life insurance policy earns value over time by the investment performance and the return rate given by the insurer. The money is credited into the account. The cash value account is tax deferred which means that the money will grow tax free until it is withdrawn.
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Group Term Life Insurance
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The premiums and benefits of a group term life policy, which is paid by an employer, can be taxed by the IRS. According to the Internal Revenue Service, group term life benefits exceeding $50,000 and/or spousal and dependent group coverage of more than $2,000 will be taxed as ordinary income. Also, employers sponsoring group term life policies exceeding $50,000 must report the premiums on their employees' W-2s as income. To calculate the premiums, employers use a table called Table I Uniform Premiums, which the IRS created as a reference.
Estate Tax
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The value of a life insurance policy can cause the policy owner to be subject to estate taxes. If the policy owner's estate, including the life policy, is valued at more than the federal estate tax limit, the property will be taxed. As of 2010, estates worth more than $3.5 million could be taxed up to 45 percent. To prevent this from happening, policy owners can assign ownership to another person, such as an adult child. This must happen three years before the death of the policy owner, or the policy will be included as part of the estate.
Policy Loans
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A policy owner can access cash from his life insurance plan in the form of a loan. He will receive the loan tax-free. The money can be use for situations such as emergencies, vacations and to fund a retirement. Policy loans do not have to be paid back. However, the death benefit will be decreased by the outstanding amount. Also, if the policy is surrendered and the loan is not paid back, the insurance company can report the loan as a "gain" to the IRS and the money will be taxed as income.
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