Is Life Insurance Taxable?
There seems to be confusion surrounding when or if an individual is subject to pay taxes on life insurance benefits. Life insurance proceeds at death are non-taxable in most situations; however, the interest or growth on the cash value inside of it can be taxed if not pulled out properly. If the growth is not taken out in the form of a loan, then the growth/earnings are generally taxable. It would then be taxed like that of the interest in bank accounts. Here permanent insurance is being discussed, not to be confused with term insurance which has no cash value.
When receiving proceeds from a life insurance policy in the event of death, the proceeds normally are not included in your income. However proceeds may be subject to estate taxes. Generally the IRS will take a portion when someone dies and leaves behind a certain amount of money. This is what happened to J.P. Morgan, Joe Robbie, former owner of the Miami Dolphins and was depicted in the movie Secretariat. These laws are very complex and should be addressed by a professional only!
Let's walk through this, you buy cash value life insurance which is the insurance wealthy people tend to buy. The tax benefits are enormous and the leverage created is beneficial in increasing the size of one's estate, therefore leaving behind a bigger nest egg. Let's say your life insurance policy has a death benefit of $1,000,000, now you add or pay premiums of $5,000 a year and you do this for 20 years. The majority of the $5,000 would normally go toward your cash portion of the policy, not to the actual internal cost. You have contributed $100,000! Let's now assume at the end of 20 years you have $300,000 saved in the policy. The $100,000 of premium paid is called your cost basis, basically principle. The extra $200,000 is accumulated interest or growth, this is the money that can be taxable if not withdrawn properly. Now you want to pull out money for a financial goal such as retirement income or college cost. The 1st $100,000 you pull out is return of premium, you are simply taken out the money you contributed so there is no tax. This is true assuming you did not deduct the life insurance premiums for tax purposes. Now the $200,000 in earnings can be borrowed from the policy, therefore eliminating the tax. You don't normally pay tax on money you borrow. The interest rate charged by insurance companies are generally pretty low, especially on the newer policies! Some of these loans end up being interest free depending on when you take the loans from the policy.
How it works is the company will generally charge you an interest rate on the money borrowed and then turn around and give you a credit on the money you borrowed. For instance they may charge you 4% and then credit you the 4% interest on the money borrowed. IT'S BASICALLY AN INTEREST FREE LOAN! And here is the kicker!! You don't have to pay it back and as long as you die with the policy in force, in other words active, then there is no tax!! Insurance companies generally have rules about how much money you can pull out and when, but they are very friendly especially when compared to the taxes you would have paid otherwise. The tax on $200,000 even at combined Federal and State tax rate of 25% would be $50,000!! Some people shy away from life insurance because of the cost which generally means they don't understand how life insurance works. Under normal circumstances your cost would be much less than the $50,000 based on a million dollar policy for someone in their 20s. Now as you get older the cost does go up, but you can also put in more money which will increase your tax benefits. Some people put 100s of 1,000s of dollars yearly into life insurance policies.
There is a myriad of facts one should be aware of concerning taxes on life insurance. To obtain a clear understanding on this subject, seek the expertise of a professional such as an experienced financial advisor. In doing so you will learn how to make the most of your life insurance policy while avoiding typical mistakes made by many.
When receiving proceeds from a life insurance policy in the event of death, the proceeds normally are not included in your income. However proceeds may be subject to estate taxes. Generally the IRS will take a portion when someone dies and leaves behind a certain amount of money. This is what happened to J.P. Morgan, Joe Robbie, former owner of the Miami Dolphins and was depicted in the movie Secretariat. These laws are very complex and should be addressed by a professional only!
Let's walk through this, you buy cash value life insurance which is the insurance wealthy people tend to buy. The tax benefits are enormous and the leverage created is beneficial in increasing the size of one's estate, therefore leaving behind a bigger nest egg. Let's say your life insurance policy has a death benefit of $1,000,000, now you add or pay premiums of $5,000 a year and you do this for 20 years. The majority of the $5,000 would normally go toward your cash portion of the policy, not to the actual internal cost. You have contributed $100,000! Let's now assume at the end of 20 years you have $300,000 saved in the policy. The $100,000 of premium paid is called your cost basis, basically principle. The extra $200,000 is accumulated interest or growth, this is the money that can be taxable if not withdrawn properly. Now you want to pull out money for a financial goal such as retirement income or college cost. The 1st $100,000 you pull out is return of premium, you are simply taken out the money you contributed so there is no tax. This is true assuming you did not deduct the life insurance premiums for tax purposes. Now the $200,000 in earnings can be borrowed from the policy, therefore eliminating the tax. You don't normally pay tax on money you borrow. The interest rate charged by insurance companies are generally pretty low, especially on the newer policies! Some of these loans end up being interest free depending on when you take the loans from the policy.
How it works is the company will generally charge you an interest rate on the money borrowed and then turn around and give you a credit on the money you borrowed. For instance they may charge you 4% and then credit you the 4% interest on the money borrowed. IT'S BASICALLY AN INTEREST FREE LOAN! And here is the kicker!! You don't have to pay it back and as long as you die with the policy in force, in other words active, then there is no tax!! Insurance companies generally have rules about how much money you can pull out and when, but they are very friendly especially when compared to the taxes you would have paid otherwise. The tax on $200,000 even at combined Federal and State tax rate of 25% would be $50,000!! Some people shy away from life insurance because of the cost which generally means they don't understand how life insurance works. Under normal circumstances your cost would be much less than the $50,000 based on a million dollar policy for someone in their 20s. Now as you get older the cost does go up, but you can also put in more money which will increase your tax benefits. Some people put 100s of 1,000s of dollars yearly into life insurance policies.
There is a myriad of facts one should be aware of concerning taxes on life insurance. To obtain a clear understanding on this subject, seek the expertise of a professional such as an experienced financial advisor. In doing so you will learn how to make the most of your life insurance policy while avoiding typical mistakes made by many.
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