There are different types of life insurance and different types of life insurance tax benefits. Understanding your options will help you choose the right life insurance for your specific situation. Use this information as a basic guide to the tax benefits of your life insurance, but also consult your financial advisor or tax preparation professional.
permanent life insurance, also called whole life insurance, pays death benefits to your beneficiaries if you die. Generally speaking, your beneficiaries are not taxed on the death benefit if the amount paid at the time of your death is not more than the stated death benefit. Simply put, if you bought a $500,000 whole life policy, your beneficiaries get the $500,000 tax-free and don’t have to claim the payment on their tax returns. This is true whether the payment is made as a lump sum or paid in annual installments. However, any interest earned on the policy in excess of the death benefit must be reported as taxable income.
Permanent life insurance also accumulates cash value, so premiums are higher than term life insurance, especially in the first few years after the policy is purchased. Your insurance company invests a portion of that money. The interest you earn is tax-free until you make a withdrawal or redeem your policy. If you wait until you retire, chances are you’ll be in a lower tax bracket.
Any interest you receive on the cash value of your policy or any money credited to your account that can be withdrawn must be reported as earned income on your tax return.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 the cash value of your life insurance or cash you deposit in an interest-bearing account. Although life insurance dividends are not taxed, the interest you earn on them is. It must be reported during the year that it is credited to your account and is available for withdrawal.
Your permanent life insurance product options include those listed below. All three carry the same obligations and tax benefits. By the way, the premiums you pay on any personal life insurance policy are not tax deductible.
Whole life insurance is generally considered the safest option because it offers a guaranteed annual premium and guaranteed minimum death and cash value benefits. Traditional whole life policies are generally classified as participatory because you can choose how to use the dividends.
Universal life insurance provides more flexibility with annual premiums. This type of life insurance policy has guaranteed maximum 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 set each year.
variable life insurance it offers fewer guarantees than the other two options, but carries the potential for higher rewards. While premiums and minimum death benefits are guaranteed, cash value is not. Most variable life insurance plans allow you to choose your investment vehicle from among several mutual funds that offer varying degrees of risk.
Term life insurance only pays death benefits, which are tax-free as described for 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.
