Two types of life insurance can be purchased. Term life insurance is the most basic. It offers a premium payment that is usually level for the term of the policy and guaranteed death benefits.
Cash value insurance, also called permanent insurance, is life insurance that provides death benefit protection to age 100 and beyond. Term life insurance and cash value insurance are not equal in their potential tax liability. The extent to which term life insurance is taxable depends on how death benefit proceeds are disbursed, while cash value insurance has an investment component that may be subject to tax.
Warning
Cash value insurance provides a cash value savings that can be used by you for any purpose. If you surrender your life insurance policy by canceling it and turning it in to the company, then any amount of money beyond the premiums you’ve paid represents a gain. This gain is taxable as income. Any death benefit proceeds not paid as a lump sum may also be subject to taxation. This is true of both term life insurance and cash value life insurance. Specifically, if the death benefit proceeds are held with the insurance company and invested after the insured’s death, or are paid to you in installment payments, any interest earned on the death benefit in both instances will be subject to taxation.
Group term life insurance may or may not be taxable. Premiums that are being paid by the employer are taxable to the employee as income to the extent that those premiums support death benefit coverage over $50,000. For example, if an employer pays a premium of $100, and $50 of that $100 goes to support a death benefit in excess of $50,000, the $50 will be treated as income to the employee subject to income taxes. Premiums that support a death benefit less than $50,000 are not taxable to the employee.
Life insurance policy dividends withdrawn or taken as cash, and other withdrawals taken from your policy in excess of the amount of premiums you’ve paid, will be considered income subject to income tax.
Significance
If your life insurance policy is taxed because the policy was terminated and there was a gain, this could negatively impact your income taxes. Cash value life insurance policies grow in value over time. The cash value represents an equity value of the policy. But the equity value could eventually represent a gain in the policy. For example, if you have paid $10,000 into a life insurance policy, and the total policy cash value was $50,000, then your total gain is $40,000 ($50,000 minus the $10,000 you paid into the policy). If your policy lapses or you cash in your policy, $40,000 would be added to your gross income for that year. This could put you into a higher tax bracket causing you to pay more in taxes.
Prevention/Solution
Keep your policy in force. By keeping your policy in force, you avoid taxation of life insurance benefits. Additionally, you can use policy loans and withdrawals up to the amount of money you’ve paid in premiums, also called your basis, in lieu of cashing in your policy to avoid taxation of benefits.
Misconceptions
A common misconception is that life insurance is completely tax free. This is not necessarily true. As long as the policy remains in force and all premiums are paid, the policy will remain exempt from income taxes. If the policy lapses, you’ll have to pay income taxes on the amount of your gain.