Life is unpredictable though it is the most valuable possession one might have. The sense of insecurity associated with life has called for the emergence of insurance to ensure protection for it. Life insurance policies might not benefit the policy holder directly. Yet, it provides satisfaction as the beneficiary will be able to obtain financial assistance in absence of the policy holder.

Now one might try to gain as much as possible from his or her life insurance policy. One advantage that a life insurance policy comes along with is that it offers tax benefits. Have a look below to know about the tax advantages as related to life insurance.

Facts to know about life insurance taxation

  • The state holds the right to tax any of its citizens.
  • In case of a life insurance, the death benefits are not considered as taxable income, and thus the beneficiary can avoid paying for it.
  • Usually life insurance policies are classified into two wide categories – ‘term life insurance‘ and ‘permanent life insurance‘.
  • Term life insurance policies don’t accumulate cash value with time. The benefits obtained from it, after the insured dies is totally tax free.
  • In case of a permanent life insurance, whether whole life or universal life, the cash value of the policy increases with time. The beneficiary might either receive the amount as death benefit or might make use of the accumulated cash value by taking out loans against it. There is no income tax withholding on the death benefits, withdrawals, loans or surrenders of a life insurance policy, even if it is credited to the cash value of the policy.

When life insurance proceeds are taxable

In certain circumstances, the benefits from a life insurance policy are taxable. Have a look below to know when you’ll have to pay taxes on the proceeds from a life insurance policy.

  1. Lump sum payments to the heir of the insured person or the beneficiary named under the policy are not taxable. However, often the insured arranges the policy returns in a way that the beneficiary receives the amount in installments. In such cases, the surplus amount exceeding the face value of the policy is taxable. Thus, taxes are levied on the monthly or yearly installment amount.
  2. If the deceased person was the owner of the life insurance policy at the time of his death, then the death benefits obtained from the policy will be regarded as a part of his estate. Thus estate taxes will be levied on it, at both federal and state levels.

Nevertheless, it is not impossible to dodge paying taxes on life insurance. Read along to know how you can avoid paying taxes on life insurance returns.

Ways to avoid taxation on life insurance death benefits

The ownership of the life insurance policy at the time of the demise of the insured, influences whether or not taxes will be levied on the policy benefits. The taxation on the death benefits of a life insurance policy can be avoided in the below mentioned ways:

  1. Transferring the policy ownership – The benefits will be considered tax-free if the insured person is not the policy owner at the time of his death. Thus, one can transfer the ownership of the policy if he or she wants to avoid paying federal taxes on the death benefits. However, if the transfer is not done three years before the death of the insured, the IRS will still consider the death benefits from the policy as a part of his estate.
  2. Irrevocable life insurance trust (ILIT) – This is a form of a trust fund where you make cash deposits. You can neither name yourself as the trustee of the trust, nor will you have any right to cancel the trust. Since you’re not the owner, the death benefits won’t be considered as a part of your estate after your death. Thus, the beneficiary won’t need to pay any taxes for it.

Life insurance benefits will be considered taxable only if it is regarded as an income for the beneficiary of the policy. The tax free benefits are applicable for any form of life insurance made under worker’s compensation insurance contracts, employer’s group plans, endowment contracts, or accident and health insurance contracts.

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