Are Life Insurance Policies Taxable?
Life insurance policies receive among the most favorable tax treatment of any savings or investment vehicles in the United States. The government has long encouraged breadwinners to make arrangements for the support of widows and orphans, and life insurance policies have long enjoyed a number of important tax benefits--subject to certain limitations.
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Taxation of Premiums
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Generally, life insurance premiums are paid with after-tax dollars. However, certain exceptions apply for business owners who purchase life insurance policies on employees or key individuals if the employer is not a beneficiary.
Taxation of Growth
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The growth of cash value inside permanent life insurance contracts, including whole life and universal life, is tax free, as long as the money stays within the policy. If the company issues a cash dividend or interest payment, however, the interest or dividend payment may be taxable as income.
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Tax-Treatment of Death Benefits
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Death benefits paid to beneficiaries are generally tax-free. However, if you sell your life insurance policy for cash or any other valuable consideration, the death benefit may become taxable under transfer for value rules. Transfer for value rules arose when speculators began buying up insurance policies from old and sick individuals to collect the tax-free death benefit. Congress enacted the transfer for value rules to restrict this practice.
Taxation Upon Surrender
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Generally, if you sell a life insurance policy before it pays a death benefit, you may be taxed on any gains in value, over and above your total contributions to the policy. However, Section 1035 of the Internal Revenue Code allows you to exchange any life insurance policy for another life insurance policy or an annuity without being subject to tax on the gain.
Taxation of Policy Loans
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Provided the policy is not a modified endowment contract, any money borrowed against a life insurance policy is considered a loan, and is not taxable as income.
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