Taxation of Life Insurance Policies

Life insurance policies are not subject to the same tax laws that other financial products are. Before buying a life insurance policy, make sure you understand when your policy may be subject to taxation.

Types

Life insurance is subject to ordinary income tax when you surrender the policy, or cash it in, and there is a gain in the policy. A gain in your policy is when you receive more money from the policy than the amount of money you've paid in premiums. You will also be taxed at capital gains rates when your policy is sold to a third party, called a life settlement. Finally, your death benefit will be included in the calculation of your estate for estate tax purposes.

Significance

Taxes will ultimately reduce the amount of benefit you receive from your life insurance policy. Life insurance death benefits can also cause your beneficiaries to become liable for estate taxes when your estate would have otherwise been small enough to avoid the estate tax.

Considerations

While taxation is rare, make sure you understand the impact of taxation on your life insurance policy. In many instances, you can avoid unnecessary taxation by not selling your policy, not surrendering it and using an irrevocable life insurance trust to hold any policies that create a taxable estate for your beneficiaries.

References

• "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004
• "Ernst & Young's Personal Financial Planning Guide, 5th Edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
• "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007