Life Insurance Death Benefits- What You Should Know about Taxation
Life Insurance Death Benefits- What You Should Know about Taxation
Almost every life insurance policy has death benefits paid at a tax-free rate. That means that if you have $200,000 in benefits, your beneficiary will receive this money without having to pay taxes on it, giving them more money in their pocket. Of course, there are rules regarding how much life insurance can be paid out based on the policy type and certain limitations of coverage, and the IRS clearly defined those rules in 1984 so that people could get more out of their life insurance coverage and the IRS could get taxes where they were due.
For single premium insurance policies, which are policies that are paid for with one premium up front for guaranteed coverage until death, there are very strict rules about taxation. The policy needs to meet a cash value accumulation test, which basically will prove that the cash surrender amount of the policy doesn't exceed the net premium that was paid to fund the policy. That means that if you have a cash value in your policy of $45,000 and you only paid $30,000 for the coverage, you may be subject to taxation of the policy. This can be corrected by insurance companies collecting more premiums to increase the value of the policy in most types of insurance, but in single premium insurance the policy is basically set in stone so you will simply have to pay the taxes that are owed.
With universal life insurance products, there is a risk corridor that is used to determine whether a policy is tax-free or not. This risk corridor basically means that your death benefit to cash value percentage has to remain at a certain range in order for the policy to be free of taxation laws. With a policy purchased at age 40, the face value cannot be less than 250 percent of the actual cash value of the policy. As you age, this percentage decreases to allow people to grow their money faster and easier. Insurers need to monitor this by refusing extra premium payments that cause the cash value to rise too high.
Provided that your life insurance policy meets these two different sets of regulations, the death benefits are paid, tax-free. That means that your loved ones can get the money that they are owed without it being taxed. Of course, if you don't meet these criteria, your earnings on the cash value and the death benefit will both be taxable and those will be taken before the remaining benefit is paid out.
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