subject: Life Insurance Tax Treatment – Understanding the Procedures [print this page] Life Insurance Tax Treatment Understanding the Procedures
The purpose of a life insurance policy, no matter which of the many types you choose to purchase, is to provide your family and any other beneficiary with financial security once you have passed away. The funds paid out by the insurance company once the policy holder has died can be dispersed in a few different ways, thus resulting in different tax treatments. If you understand these, you will be better able to make future tax preparations.
Unlike health insurance premiums, your life insurance premiums are not tax deductible. This is because the premiums are not considered an expense. The two exceptions to this are when a charity owns and will be the beneficiary when the policy holder dies or if the premiums are being paid because of an alimony agreement.
Traditionally, the death benefits of your life insurance policy will be paid when the policy holder has died. However, something called accelerated death benefits is when a portion of the benefits are paid out because the policy holder is terminally ill with less than 12 months to live. Accelerated death benefits are tax free.
One type of life insurance called a matured life contract pays the benefits when the policy term reaches maturity or expires. In this situation, the proceeds fall under the category of regular income and are not considered tax free by the IRS.
Some life insurance policies pay dividends because a portion of the premium you pay is invested. These dividends are only taxed if they exceed the cost of the policy. Since it is rare for these dividends to come to such a high amount, they rarely end up being taxed. Therefore, the IRS sees your dividends as a partial refund of premium. That is why any amount over the cost of the premium is considered income and will be taxed.
Permanent life insurance policies build cash value that can be borrowed, collected if the policy is surrendered, or paid out with the death benefit when the insured passes away. In general, if the money is borrowed, it is not taxable unless the life insurance policy is cancelled before the money is paid back. If the policy is surrendered and the cash value is collected, it will be taxed only if the amount exceeds what your premium payments have been. When the cash value is paid out with the rest of the death benefits, it is considered part of the policy benefits and is not taxed.
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