There are different types of life insurance and different kinds of tax liabilities for the various payouts on benefits. Understanding your options will help you choose the right life insurance for your specific situation. Use this information as a basic guideline, but consult your financial advisor or tax preparation professional, too.
Permanent life insurance, also called whole life insurance, pays death benefits to your beneficiaries if you die. Generally speaking, your beneficiaries do not pay tax on the death benefit if the amount paid at your death is not greater than the stated death benefits. Simply put, if you bought a $500,000 whole life policy, your beneficiaries get the $500,000 tax free and do not have to claim the payout on their income tax returns. This is true whether the payout is made as a lump sum or paid in annual installments. However, any interest earned on the policy over and above the death benefit must be declared as taxable income.
Permanent life insurance also accrues cash value, which is why the premiums are higher than they are for term life, especially during the first few years after you’ve purchased the policy. A portion of that money is invested by your insurance carrier. The interest you earn is tax-free until your make a withdrawal or cash out your policy. If you wait till you’re retired, you’ll most likely be in a lower tax bracket.
Any interest you receive on your policy’s cash value or any money credited to your account that can be withdrawn must be reported as earned income on your tax return. This includes interest you earn on loans you make to others using cash value from your life insurance or from cash you deposit in an interest-bearing account. While life insurance dividends are not taxable, the interest you earn on them is. It must be reported during the year that it is credited to your account and available for withdrawal.
Your permanent life insurance product options include those listed below. All three of them carry the same tax liabilities and benefits. By the way, the premiums you pay on any personal life insurance policy are not tax deductible.
Traditional whole life insurance is generally considered the safest option because it offers a guaranteed annual premium and minimum guaranteed death benefits and cash values. Traditional whole life policies are usually classified as participating because you can elect how you use any dividends.
Universal life insurance provides more flexibility with the annual premiums. This type of life insurance policy has guaranteed maximums of premiums and guaranteed minimums on cash value and death benefits. There are no dividends, but universal life insurance policies to earn interest at a credited rate, which is established each year.
Variable life insurance offers fewer guarantees than the other two options, but carries the potential for greater rewards. While premiums and minimum death benefits are guaranteed, cash value is not. Most variable life insurance plans let you choose your investment vehicle from several mutual funds offering varying degrees of risk.
Term Life Insurance only pay death benefits, which are tax-free as described for whole life. Term life insurance policies have no cash value and do not accrue interest or pay dividends. The premiums you pay are not tax deductible.