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Life Insurance – Understanding the Tax Implications

Permanent life insurance policies (often referred to as “Whole Life Insurance”) are a contract between a policyholder and an insurance company whereby the insurance company promises to pay a designated beneficiary a sum of money (a death benefit) upon the death of an insured in exchange for a premium. In most cases, when the designated beneficiary receives the death benefit, the life insurance proceeds are usually “tax-free” and do not need to be reported as taxable income on the beneficiary’s income tax return.

While the taxation of life insurance proceeds at death are generally tax-free, there are times during the life of an insurance contract when the owner of the life insurance policy may be subjected to income tax. With whole life insurance, part of the premium that you pay goes toward the cost of the life insurance and part of the premium goes to an investment component in the policy (i.e., build-up of cash surrender value). With every premium payment, this “cash surrender value” of the policy continues to grow. The IRS does not tax the gains on a whole life insurance policy (dividends or build-up of cash surrender value) as long as the gains stay in the policy. However, if you choose to take out a “loan” against the policy or choose to receive dividends paid out to you in cash, there is the possibility that you could be subjected to income tax in certain situations.

Dividends

When you receive a dividend on your life insurance policy, you have a few options. Depending on the terms of the policy, as a policyholder you generally may choose to receive the dividend in any one of the following manners:

  • dividend may be used to purchase paid-up additional insurance;
  • dividend may be used to reduce premium payments;
  • dividend may be left to accumulate with the insurance company on which interest may be earned (interest earned each year on dividend is taxable);
  • dividend may be used to pay down a loan (if any) on the policy; or
  • dividend may be paid out to the policyholder in cash.

As mentioned earlier, the IRS does not tax the gains on a whole life insurance policy as long as the gains stay in the policy. Therefore, if you use the dividend to purchase additional life insurance, reduce premium payments, leave to accumulate with the insurance company to earn interest, or pay down a loan on the policy, you won’t owe any income tax on the dividend. However, if you ask the insurance company to mail you a dividend check, you could owe taxes on the dividend. You get the return of your insurance premium payments back tax-free, so you won’t owe any income taxes as long as your total dividends received are less than the total premiums that you have paid into the policy. If you receive more dividends from your policy than you paid in through premiums, the “excess” dividend will be considered taxable income which will need to be reported as such on your individual tax return.

Policy Loans

You can generally take a loan on an insurance policy up to the cash surrender value of the policy. The insurance company will charge you interest on the loan but, generally, this interest is not actually paid by you, but is added to the amount of the loan. You are not required to repay a life insurance policy loan but you can, at any time, while the insured is alive. If you do not repay the loan, the policy proceeds paid to the designated beneficiary at the insured’s death will be reduced by the amount of the loan (plus interest). Also, if the amount borrowed (plus interest) ever exceeds the cash surrender value of the policy, the policy can terminate if additional amounts are not paid into the life insurance policy. If this occurs, any outstanding loan at the time that a policy is either surrendered or allowed to lapse is treated as an amount received and may result in taxable income to the policyholder.

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