In addition to life insurance proceeds providing a financial cushion to loved ones who are left behind, there are also a number of advantageous tax benefits that go along with owning certain types of life insurance plans. In fact, life insurance policies actually hold a unique tax advantaged status among financial products.
How Interest On Life Insurance Cash Value is Handled
One of the biggest tax-related benefits to owning permanent life insurance is that there is no income tax on interest or other earnings that are accumulated in the cash value component of a permanent life insurance policy. This is because the funds within these types of accounts are allowed to grow on a tax-deferred basis.
There are also no tax consequences if funds from the policy’s cash value component are borrowed. These loans are treated as if they were debts – and they are therefore not considered to be taxable distributions from the cash accumulation of the policy.
An additional benefit here is that these life insurance policy loans are also not required to be repaid. The only consequence is that if the insured passes away with any amount of unpaid loan still left on the policy, that amount will simply be deducted against the total amount of death benefit proceeds received by the insured’s beneficiary(s).
Tax Treatment of Death Benefit Proceeds
In addition to advantageous tax treatment of a life insurance policy’s cash value, death benefit proceeds are also received free of income taxation by the policy’s beneficiary. This can be quite beneficial to the insured’s survivors, as they will know exactly how much money will be received in order to pay off debts of the decedent and other financial obligations that have been earmarked for these particular funds.
Therefore, when determining how much a beneficiary will need, and barring any unforeseen circumstances, a policy with a face amount of $100,000 will actually pay out $100,000 to the named beneficiary of the policy.
Life Insurance and Estate Taxes
There is yet another area in which life insurance can provide tax benefits. This is the payment, reduction, or avoidance of estate taxes. In many ways, life insurance plays an active role in the estate planning process – primarily for its tax advantages. However, in order for this process to work as intended, the life insurance plan must be properly structured.
In doing so, it is important to note that even though life insurance policy proceeds are received income tax free by the beneficiary, these proceeds could be subject to possible estate taxation. Therefore, it is essential to structure the policy in the correct manner.
The U.S. system of estate taxation can potentially impose a tax on the transfer of a decedent’s taxable estate upon death. This tax is typically imposed – regardless of whether the decedent’s assets are transferred through a will, via their state’s laws of intestacy, or otherwise.
Due to such taxes, a decedent’s estate could potentially owe taxes on a large portion of the value of his or her estate. Therefore, when estate taxes are a potential concern, a life insurance policy may be put in place for the purpose of paying such taxes.
When doing so, however, it is important that the insured should not also be the owner of the life insurance policy. This is because if the insured is also the policy owner, the value of the life insurance proceeds could then be included in the estate’s value – and potentially be subject to additional estate taxation.
There is, however, a solution. By moving ownership of the life insurance policy out of the insured’s ownership and into the ownership of a trust, for instance, the value of the policy’s proceeds will not be included in the insured’s total estate – and he or she will therefore not owe taxes on this amount.
Another solution is to have the adult children of the insured – if applicable – act as both owners and beneficiaries of the life insurance policy. By setting it up in this manner, the adult children could essentially “loan” the life insurance proceeds to the decedent’s estate in order to provide the funds that are needed to pay the estate taxes.
The Bottom Line on Life Insurance Benefits
In addition to simply paying out a benefit upon an insured’s death, life insurance policies can also be a primary component of one’s overall financial, retirement, and estate planning strategies.
Life insurance can help you and your loved ones to protect assets, maintain a certain lifestyle, follow through on financial promises, pay off final expenses and other pressing debt obligations, and attain substantial tax related advantages.