Life insurance is a financial product that provides a death benefit to your beneficiaries when you die. This money may be used for any purpose, and is generally exempt from taxation. However, there are some instances when life insurance may be subject to capital gains. You should know when these situations occur so you understand your tax liability.
When your life insurance policy is taxed at capital gains rates, it's because you've sold your life insurance policy to a third-party investor. Ordinarily, life insurance is passed to your beneficiaries. When this happens, there is no tax due on the transfer. But, when you sell your insurance policy to an investor, it's treated as an investment subject to capital gains tax. The third-party investor is called a life settlement company. The company purchases your policy if it is a permanent life insurance policy. The company pays you a dollar amount between the current cash surrender value and the death benefit amount. In exchange, you sign over all ownership rights to the company and the settlement company becomes the beneficiary of the policy.
The transfer of the policy is considered, by the IRS, to be an investment. This means the IRS treats your exchange with the settlement company as a capital gain. You must pay capital gains tax on the gain you experience. The gain is determined by calculating the difference between the total amount of premiums you've paid into the policy and the amount of money you receive from the settlement company.
The benefit of paying capital gains tax on your transaction is that it is lower than paying income tax on your transaction. This gives you more money as a result of the transaction than if you could have surrendered the policy for the same amount of money that a settlement company would give you.
The disadvantage to paying capital gains tax on your life insurance policy is that you've lost your life insurance policy. Instead of selling the policy, consider keeping the policy and taking a policy loan against the cash value built up in the policy. Policy loans are tax-free, and you may be able to receive more money from your policy through a policy loan than you could sell it for net of capital gains tax.