Tax Benefits of Life Insurance
Unlike other types of inheritances or income, life insurance policy benefits are tax-free. Investments or the cash value of a policy also grow tax-free in most policies.
We’ve written before about how life insurance can be a wise investment, when structured correctly (it is this structuring or designing that is often done wrong and gives cash value life insurance a bad rap). Say you need money to pay for a home, or supplement your income. There are two ways to access that cash, both with significant tax advantages over selling shares in a mutual fund.
1. You can withdraw cash on a tax free basis. Cash value within a life insurance policy can always be withdrawn on a tax free basis IF the policy holding the money is kept active. Doing so may reduce your death benefit, but you won’t pay taxes on money taken out as long as you follow the rules of the contract.
2. You can borrow against the cash value. Another option is leaving the money in the policy, but taking out a loan against it. Most insurance companies will lend you money, holding your policy as collateral. Because a loan is not a taxable distribution, you can borrow against your cash value to supplement income or make a large purchase. A little caveat to keep in mind is that you will pay interest on loans—either out of pocket or as an increase to the loan balance. Often times this is countered with a credit, creating a minimal charge or none at all. Taking out loans reduces your death benefit and the overall cash value of the policy. If the policy lapses or is surrendered with an outstanding loan, a portion may be taxable.
3. Death benefits are usually income-tax-free. The beneficiaries of your life insurance policy will likely not have to pay federal income tax on death benefits. If you bought a $500,000 policy, you can be assured that they will receive $500,000 in benefits with no deductions and no withholding required.
4. Estate taxes aren’t inevitable. Your tax advisor or attorney can explain ways to avoid potential estate taxes through a transfer of policy ownership to another person or trust. Usually this means transferring the policy more than three years before your death.