subject: Life Insurance Taxation- Information You Need to Know Before You Buy [print this page] Life Insurance Taxation- Information You Need to Know Before You Buy
Life insurance and taxes are something that a lot of people know very little about. This usually comes from the idea that most people have that insurance is tax-free. This is usually the case for most life insurance policies but there are some tax rules that you have to know about before you invest in life insurance. The goal of life insurance is to provide tax-free death benefits, but since investment policies were created, the laws have been changed to make sure that people aren't getting a free path to investing, as well.
Life insurance policies that have cash value, such as a universal life insurance policy, have to have a specific risk corridor, or benefit to cash value ratio. If the ratio is under a certain percentage, the policy remains tax-free and people can get the benefit without paying taxes. However, if the cash value grows too much, people may risk paying taxes and penalties on the increased cash value when they withdraw the money or when the policy is brought up for payment of the death benefit. In this situation, insurance companies also have the right to refuse premium payments that would increase the cash value any higher.
With single premium life policies, there are tax rules as well. A single premium policy is one where you pay a lump sum for coverage and then you get that coverage for the remainder of your life because the policy is already paid for. This policy has to meet a cash value accumulation test, which basically states that the cash value at surrender doesn't exceed the single premium that was paid in the first place. If this is the case, the policy has no taxes. If not, then you are likely going to be subject to high taxes and penalties on the excessive cash value because it exceeds the regulations.
In 1984, when investment life insurance products began creating a stir, the IRS realized there were no rules in place for these policies, allowing people to invest at tax-free rates and they wanted to make sure that they put a limit on that. So many people were earning a lot of money that they didn't have to pay taxes on, so to avoid a rush of life insurance customers who were looking to evade taxes in investing, these rules were put into place to define life insurance policies and to make sure that taxes were paid where they were due.
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