Know the Tax Benefits of Your Life Insurance Policy

Life insurance policies can carry a host of tax consequences for policyholders and beneficiaries that can easily catch you by surprise. This can be mitigated with proper communication and planning as these consequences are most likely to strike if the proceeds were cashed out early or held by the insurance company after the policyholder died.

However, life insurance remains a popular choice for financial planning because these policies also entail several tax advantages that other assets don't. Whole or permanent life insurance, in particular, can provide security for your loved ones after your death. It also functions as a financial asset that can defer or avoid taxes more effectively than stocks or retirement accounts.

Your tax advisor or estate planning professional can help you determine if life insurance is suitable for your financial goals and if these transactions are prudent. Bearing that in the mind, your life insurance policy may entail the following tax benefits.

1. Tax-Free Exchanges for Other Life Insurance Policies and Annuities

As with any other financial asset, paying into a life insurance policy and then deciding you would like something else isn't as straightforward as returning an item to a store. Should your personal circumstances change, you may change your investment objectives and decide that a different life insurance policy¹ or another vehicle would best suit your needs at this juncture.

Provided that the current policy is exchanged for a new one, or an annuity, you won't have any tax consequences. This maneuver is called a tax-free 1035 transfer² for the section of the tax code it refers to. It functions similarly to IRA and 401(k) rollovers when it comes to managing your retirement assets as you change careers or financial institutions.

However, it must be a 1:1 exchange. You cannot receive a check for any amount then simply buy a new policy. You also cannot change an annuity to a life insurance policy and have it be tax-free.

2. Early Distributions From Life Insurance Are Tax-Free to the Extent of Basis

Similar to holding stock, the cash value of your life insurance policy will grow tax-free provided that no distributions are taken. But while you recognize a capital gain on your tax return after selling the stock, this isn't the case for taking an early distribution from your life insurance policy.

If you make a partial withdrawal from your life insurance's cash value, you would only owe taxes³ on the amount that exceeds your basis (premiums paid). For example, if you paid $15,000 in premiums, and the cash value of your policy is $50,000 but you only withdraw $10,000 for a major life event, this distribution would be tax-free since it does not exceed your $15,000 basis. However, if you surrendered the entire $50,000 early, then you would owe taxes on the $35,000 portion that exceeds your basis. Unlike stock sales though, early distributions in excess of basis are taxed at the ordinary rate and not the capital gains rate.

3. Accelerated Death Benefits in the Event of Severe Illness

Accelerated death benefits, or viatical settlements, refers to an early surrender of your life insurance policy if you are terminally ill or have an incapacitating illness or disability. You must inform the insurance company of your condition and meet the requirements under the policy to allow for tax-free accelerated death benefits.⁴

4. Tax-Free Loans Against a Life Insurance Policy

If you're facing an emergency and need short-term cash, or you'd like to start a business and forego the lengthy loan application process, borrowing against your life insurance policy⁵ can be an attractive option.

Unlike taking a partial or whole early distribution of your life insurance policy's cash value, the policy remains intact and you can borrow an amount exceeding the premiums you paid without triggering any tax consequences (provided the policy is not a Modified Endowment Contract, or MEC). Using the previous example of a policy with a $50,000 cash value and $15,000 in premiums paid, $50,000 could be borrowed and there would be no tax consequences simply for taking out this loan.

However, all of this hinges on the policy still being in effect. If the policy lapses, you could owe taxes on the loan proceeds. You can also choose not to repay the loan and simply have the balance deducted from the death benefit or repay as much of the loan as you can to keep death benefits intact. Additionally, these benefits only apply if the policy is not a modified endowment contract (MEC) which would result in tax consequences if an early distribution is made.

Ultimately, life insurance carries several key tax benefits and other properties that make it important to include in your investment objectives. Depending on your lifestyle and financial goals, the tax advantages, as well as potential tax consequences, need to be considered when deciding which policy best suits your needs.