Life Insurance Tax
While all life insurance provides security for financial dependents in the event of a death, some types of life insurance also offer tax advantages. Life insurance policies which build cash value or have an investment option can be used to defer taxes on investment returns. Some policies may provide ways to avoid paying estate taxes on the death benefit.
Knowing which types of life insurance can save money on taxes can help consumers make informed decisions when buying a life insurance policy. Read further to learn more about whether your life insurance policy is taxed.
Term Life Insurance
Term life insurance offers temporary coverage which provides a death benefit for a pre-set term and has no cash value. Term life coverage usually has lower premiums than permanent life policies, but this doesn’t mean term life insurance is a better value, since when term life expires, the insured must repeat the application process and the new premiums will likely be higher. Term life insurance has no cash value, but death benefits are exempt from income taxes, although they may be subject to estate taxes.
Whole Life Insurance
Whole life insurance is a type of permanent life insurance which has a cash value derived from the premiums paid into the policy. Whole life usually pays a guaranteed interest rate on the cash invested in the policy, and income tax on the interest is deferred until the money is withdrawn from the policy. The insured can use the cash value as collateral for a business or personal loan without paying income tax on the investment, and death benefits are not subject to income tax, but estate taxes may apply.
Universal Life Insurance
Like whole life insurance, universal life insurance is a permanent life policy with a cash value. Universal life insurance usually invests the cash value in financial instruments like stocks and bonds. The potential for returns on universal life is higher than for whole life, but there is a greater potential for loss and variability with the returns. Returns on investments in universal life insurance are also tax-deferred until the money is withdrawn from the policy. As with term and whole life, death benefits are free from income taxes, but may be subject to estate taxes as well depending on your form of estate planning.
Variable Universal Life Insurance
Variable universal life insurance allows the policyholder to determine how the cash value of his policy will be invested. The insured person may choose from several options with varying amounts of risk. He may choose more than one type of investment to maximize his returns and minimize his risk. Variable universal life is a type of permanent life insurance, and all returns on investments are tax-deferred until the money is withdrawn from the investment account. Death benefits may be subject to estate taxes.
Irrevocable Life Insurance Trust
While the death benefit on insurance policies is not subject to income taxes, it may be subject to estate taxes, which in the United States are 35%. In an irrevocable life insurance trust, the insured transfers ownership of a cash value life insurance policy to a trust, which can act as a tax shelter for beneficiaries if the insured dies. The life insurance trust is exempt from estate taxes since it is not considered part of the deceased’s estate. The trust must be administered by a trustee, other than the insured, who has no interest in the trust.
Survivorship Life Insurance
A survivorship life insurance policy covers two people, usually a married couple. It may be a first to die policy, which pays benefits to the survivor, or a second to die policy, which pays benefits only after the second insured policyholder dies. Survivorship policies can offer substantial tax benefits for those with large estates, but the tax laws on these policies are not clear, and it is best to consult an attorney or accountant specializing in estate planning before deciding to purchase a survivorship policy.
Death and Taxes
The greatest tax benefits from permanent life insurance are those which protect the survivors from income and estate taxes. Life insurance may be used as way to cover estate taxes, so survivors don’t lose a large part of their inheritance, or it can be used as tax shelter while the insured is still alive, to defer paying income tax on investment returns. For large estates the best way to avoid taxes is to establish an irrevocable life insurance trust, which is independent of the insured’s estate and sheltered from estate taxes.
Legal Aspects
When permanent life insurance is used as a tool in estate planning, it is best to consult an attorney to determine which type of insurance offers the greatest tax advantage. Tax laws are complex, and only an attorney who specializes in tax law or estate planning can determine how best to take advantage of life insurance when planning a legacy for survivors or beneficiaries. Permanent life insurance is only one tool, and an attorney can help in setting up a plan to avoid as many taxes as possible.
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