Is Life Insurance Taxable?

Is Life Insurance Taxable

Is life insurance taxable? If the premiums are being paid with after-tax dollars then typically the death proceeds are not taxable. However, there can be some exceptions to this. The following is useful information that you should know if you plan to acquire life insurance for this reason. 

Is Life Insurance Taxable Plan Benefits?

  1. Indeed, death benefits are usually exempted from income tax.

 Once an insured died, then the beneficiary is sure to get the death benefits in full. According to IRS, death benefits from any life insurance plan are all tax-free. However, an exemption to this rule is when death benefits come from installments rather than a lump sum. The beneficiary is required to pay tax on the interest gained for each payout. 

  1. A permanent life plan accumulates cash value within the period of the policy, and these are tax-deferred.

This cash value is the total amount of premium paid and investments minus different insurance fees. All of these cash gains from the policy are tax-exempts. Cash gains are only subjected to income tax charges if it will come out as surrenders or withdrawals. 

  1. Policy distributions are also tax-free up to basis

but you need to equip yourself with the right knowledge on Internal Revenue Code section 7702A. This information might be new to you. Common examples of distributions are partial withdrawals, dividends, full surrender, and policy loans. Also, a type of policy known as Modified Endowment Contract is qualified under Section 7702. However, the MEC policy does not meet important requirements under this Section. 

There are myriad life insurance benefits, and each one is taxed differently.

Having life insurance coverage is the best way to ensure financial security for your family in case if something happens to you.

You can choose from two types of insurance coverage.

  • Term Life– It is a type of policy that can offer coverage within a definite period. Beneficiaries can get death benefits in case of unfortunate events that could happen to the insured. All the benefits of the policy are tax-free. 
  • Permanent– This insurance policy offers investments from different permanent policies such as variable, universal, and indexed plans. These plans accrue cash value over time, but tax implications for this coverage type are more complicated than term life. 

Possible Exemptions for Tax-Free Insurance Policy

  1. Payment for after-tax fund

Benefits from life insurance coverage are exempted from income tax if you pay the premium with after-tax funds instead of having it deducted. 

For instance, an insured has a 1 million dollar insurance plan. The premium is deducted from the tax returns, and the beneficiaries will not get the death benefit’s full amount. They need to pay 30 percent of the benefits to taxes. Paying premium through after-tax funds can give your beneficiaries the security against paying higher taxes.

  1. Compliance to IRS

As an insured, it is good to know and understand taxation according to the Internal Revenue Code. A life insurance plan is an insurance and, at the same time, an investment that can offer financial security in case of unforeseen events like the death of the insured. The Section under the Revenue Code 7702 regulates the connection between these two benefits. The IRS defines what is perceived by the federal government as life insurance to make it tax-free.

There are two essential requirements for a policy to become life insurance. 

  • First is that life insurance policy is under a specific law. The law requires that a policy must gain an insurable interest. 
  • Second, a contract under a life insurance policy should meet either of the IRS tests. These tests are the GPT or guideline premium corridor and the cash value accumulation test. 

Under the CVAT cash value, it must not exceed the required amount to fund death benefits. 

GPT test has two essential components: death benefits and premium components.

  • Under the Death benefit component, death benefits given to the benefits must be a percentage of the accumulated cash value. 
  • The premium restricts by the amount of premium you need to pay for the policy. 

These requirements exist to protect the policy in comparison to its cash value. In case a policy does not meet either of the two conditions, it is only investment and is not eligible for tax exemptions. The good news is that insurers design policies according to these two requirements. 

Life insurance policies comply with either the GPT or the CVAT test, and all policyholders must choose between the two tests. It is the reason why people who are planning to get insurance coverage must know these requirements. It will significantly impact your death benefits, cash value, and premiums. The right insurance agent can provide you with detailed information and select the best test according to your personal needs and preferences. Be mindful that once you choose a test, you will not be able to change it.

  1. Modified Endowment Contract or MEC

Policies under MEC are a type of life insurance coverage that accumulates a considerable amount of cash value for a short period. The IRS under 7702A will determine if a policy is MEC using the 7-pay test. This test provides a specific limit for the premium you need to pay for the first seven years. A policy is considered as MEC once it exceeds the limit for paid premium within seven years. Distributions before death, such as loans, dividends, and withdrawals, are subjected to stricter tax rules than non-MEC policies. 

For instance, if a policyholder is paying 10,000 dollars for their indexed universal plan for the past seven years, it can go into MEC if you pay 12,000 dollars in 5 years. Once it goes to MEC, you will not be able to switch back to the regular plan even if you pay fewer premiums in the future. A reliable insurer will notify policyholders in case of an excess payment. It will give it back as a premium refund within 60 days to avoid the policy to go into MEC status. 

MEC Tax Status

If your policy goes into MEC, it is non-taxable if you will not make any distributions throughout the policy’s lifetime. MEC is known as a life insurance plan, so it means that it is tax-free. The only difference between the non-MEC and MEC policy is the tax treatment for distributions. 

Cash value under MEC is taxable once you consider making contributions throughout your lifetime. There is a term known as “last in, first out,” which means the first gain in cash value is taxable under distributions. Once all profits are drained from the policy, then it will go tax-free. For instance, a policyholder has a 10,000 dollars policy and cash value of 12,000. It means that the policy accumulates 2,000 dollars as cash value. All withdrawals under 2,000 are taxable, and excess from that amount is tax-free. Also, any withdrawal done earlier than 59 ½ years old is subjected to a 10% penalty. 

      4. Goodman’s Triangle

In 1946, it was ruled that all premiums given to beneficiaries and given to another party are considered a cash gift and, therefore, subject to relevant tax laws. One can avoid this kind of circumstance by ensuring that the original beneficiary will benefit from the coverage. 

To keep from having tax issues on life insurance proceeds, make sure you only have two parties take part in the life insurance contract.

 

Advantages of NON-MEC Plans

It is good to know that most insurers organize their life insurance policies to comply with 7702 and 7702A to ensure that it falls under the non-MEC policy. In short, for non-MEC policy, distributions that are less than the premium you paid for are tax-free. It means the following:

  • Withdrawal– If you will withdraw a lower premium than what you paid for, then it is tax-free, and all withdrawals that are higher than that are taxable. 
  • Surrender– If you want to surrender the policy and the value is lesser than the amount you paid for, it is tax-free. You need to pay tax if it is higher than the total amount of premiums. 
  • Dividends– Policyholders from the mutual company will get tax-free dividends as long as it is lower than your paid premium. All dividends higher than the amount of the premium are taxable. 
  • Policy Loans– Policyholders can borrow money from the cash value under the permanent plan. All paid interest for the loan is exempted from income tax. However, if you get a loan using your policy as collateral, a lower premium is non-taxable, then higher is taxable. 

Controlling Tax Benefits Of Your Life Insurance 

Life Insurance Coverage as Non-Taxable Income Supplement

As previously discussed, a policyholder can get lots of benefits from a life insurance plan. It is a good income supplement for your family in case of your passing, which is tax-free. It is also possible to make withdrawals, get a loan, and acquire dividends without tax based on the policy. All investments gained from the policy in terms of cash value are tax-deferred. 

Life Insurance Coverage is Useful for Chronic and Dreaded Illnesses 

Those at the age of 65 are concerned about having chronic or dreaded illnesses later on in life. One can opt for policy riders and life insurance to get non-taxable benefits in chronic and dreaded diseases. It is also the same with a long term care insurance plan, but it is part of the life insurance coverage. The difference from LTC is that benefits from chronic and dreaded diseases rider add up to death benefits. There is also accelerated death benefit, which is also known as a living benefit and permanent coverage. This kind of benefit is utilized as a supplement to cover expenses from chronic or dreaded diseases which are non-taxable. 

Low Retirement Taxes

Some experience lower tax rates after retirements in case of a withdrawal from 401k or the IRA. However, many elder couples suffer from higher income tax rates after retirement that depletes their financial capital in the future. 

Couples with a combined income not higher than 32,000 dollars are tax-free, and then 85 percent of the total income under Social Security Income is taxed once it reaches more than 44,000 dollars. Many couples take advantage of getting a permanent life insurance plan to lessen the impact of what they called “tax torpedo” in their Social Security income by:

  • You can limit the forced taxation by accumulating income from a life insurance plan. Withdrawals and loans from life insurance are non-taxable. If you need to withdraw cash from your Social Security income, you can avoid taxes by withdrawing cash value from the policy.
  • You can leave higher income-generating assets to your spouse. While Social Security tax is lenient to single individuals, those spouses of deceased policyholders are sometimes penalized. You can choose to leave your spouse with higher Social Security survivor benefits and the death benefits to pay lower taxes. 

Important Note: 

To summarize everything, life insurance policies can get a more favorable tax break than other investment vehicles like annuities and mutual funds. Death benefits received by your beneficiary are non-taxable, and all cash value accumulated from the policy is tax-deferred. Also, policy distributions in the form of surrenders, loans, withdrawals, and dividends are non-taxable according to the insured’s total premium. 

Having enough knowledge about taxable and non-taxable policy and benefits is essential for your protection and your loved ones’ future. 

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About Coach B.

After starting his financial career with Phoenix Home Life Insurance Company back in 1992, Scott decided he wanted to provide people with an easier and more enjoyable way to buy life insurance. That was the start of Coach B. Life Insurance, whose mission is to be transparent, honest, and helpful to customers — without ever bugging or pushing them.

In the years since then, he has worked tirelessly to improve the process of shopping for insurance. His goal is to make sure that everyone who comes to Coach B. — whether they end up buying a policy or not — has the best possible experience.

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