One of the main advantages of life insurance is that payment to beneficiaries is free. Because life insurance benefits in the event of death can run into the millions of dollars, it's a significant benefit to buy (and receive) life insurance.
But there are other aspects of life insurance that the tax office will not overlook. Here's an overview of when to prepare for a tax bill.
Withdrawal of money from the cash value
If you have a cash value life insurance policy, you can usually access the money by withdrawing or borrowing or abandoning the policy and terminating it.
One of the incentives for buying cash value life insurance is to have access to the money that accumulates in the policy. When paying premiums, payments are generally made in three places: cash value, insurance fees, and policy fees and expenses. Money within the cash value increases without taxes, depending on the interest or income from the investments made (depending on the policy). But after you withdraw the money, you may face taxes.
The money is withdrawn generally consists of two parts:
Cash received from premium payments made. This component of a tax is not taxable. In life insurance, this part is called the "policy basis."
Interest or investment income. This part is subject to income tax. Your life insurer can tell you how much of the tax is "above basis" and taxable.
If your life insurance plan is a "modified endowment agreement" or MEC, different tax rules apply, and it is best to consult a financial professional to understand the tax implications.
You give up the policy.
It may happen that the insured no longer wants or no longer needs the life insurance policy. You can get the refund amount from the policy, and the insurer will cancel the coverage. The sum you receive is your cash value minus the surrender charge. You can generally expect to receive a surrender charge within the first 10 to 20 years of purchasing the policy, and over time the surrender charges gradually disappear.
However, no fee will be charged for the full refund amount. The tax will be applied to the amount received minus the policy basis. This tax basis reflects the income from the investments you have made.
You have a loan policy, and the life insurance ends.
If you have a cash value policy and take out a loan, the loan is not taxable while the policy is in effect. But if the policy ends before you pay off the loan, you could get a tax bill. For example, if you cancel your policy or if it expires, your coverage will end.
The taxable amount is based on the loan amount that exceeds the policy basis. Remember that the basis of the policy is the part you paid as a bonus. The "above" amounts are based on interest or investment gains on the cash value.
One way to access all of your money and avoid taxes is to withdraw the amount that is the basis of your policy; it is not taxable. Then access the remaining cash value with a loan, which is also tax-free.
Sell the life insurance policy.
There is a market for existing life insurance policies, especially life insurance policies with monetary value insuring terminally ill patients or those with a short life span. Transactions involving policyholders with terminally ill illnesses are called "viatical settlement." It's about an investor, like a business specializing in buying policies, paying for the policy, becoming the policyholder, and then purchasing life insurance upon your death.
Viatical settlements are usually used as a way for patients to get money for their medical bills, especially when selling a life insurance policy means getting more money than just handing over cash.
Fortunately, the IRS does not consider any part of what you receive for a viatical settlement. Under IRS code 101 (g)(2), an amount paid by a viatical settlement provider is treated as a death benefit payment, and death benefit payments are not taxable.
A lifetime contract is a similar operation but involves an insured person who is not terminally ill. In these cases, the IRS does not consider the earnings as a death benefit. Some of what you receive may be taxable.
You are a life insurance beneficiary who receives interest on a death benefit.
Most life insurance payments are made all at once, immediately after the death of the insured. But some recipients choose to delay the payment or receive the payment in installments over time. Where these late payments include the life insurer's interest, the interest may be charged.
The life insurance payment goes to a taxable asset.
Most life insurance payments are made tax-free directly to life insurance beneficiaries. But if a beneficiary has not been named or has died, where does the life insurance death benefit go? It is included in the insured's assets and can be taxed with the rest of the net assets.
This could result in significant tax expenditures, especially given state and federal property taxes. While federal property taxes do not impose a tax on the first $11.7 million per person (in 2021), state property taxes could have significantly lower exemption levels.
Another possible unfortunate scenario is that a property is below the exemption level. Still, a large life insurance payment to the property pushes it beyond the taxable territory's exemption limit.
This should be avoided by designating the primary and potential beneficiaries of life insurance and keeping those selections up to date.
FOR MORE INFORMATION OR TO SEE HOW JIM McCLAFLIN, EA, NTPI FELLOW CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.
THANKS FOR VISITING.
Jim McClaflin, EA, NTPI Fellow, CTRC