Life insurance taxation

Life insurance taxation is an important subject as relates to your overall financial situation.  Life insurance contracts have several tax features which make them unique and advantageous as an asset class.  We will discuss several aspects of life insurance taxation.  We will discuss tax advantages of life insurance here related to the death benefit, the withdrawal or surrender of the cash value, and the dividends from the policy.

Taxation of the death benefit

Death benefit payments are typically paid income tax free to the beneficiary.  They can, however, be subject to the estate tax.  There are various strategies for managing the estate tax liability including irrevocable life insurance trusts (“ILITs”).  This is a complex subject and we emphasize the importance of consulting with the appropriate advisers in carrying out such estate planning strategies.

Taxation of cash value upon withdrawal or surrender

The cash value of the life insurance policy can be withdrawn tax free up to the basis of the policy, after which point the cash value is taxed.  This is a unique and advantageous feature of life insurance and is known as the first in first out (“FIFO”) convention.  It is important that the life insurance policy meet certain requirements in order to qualify for FIFO treatment.  If a life insurance policy is over funded as per these rules it could be classified as a modified endowment contract (“MEC”) which would deem it to be treated as an annuity for tax purposes, which would include last in first out (“LIFO”) treatment of the gains as well as a 10% penalty for early withdrawals (prior to age 59 1/2).

Taxation of dividends

Unlike taxes on dividends from capital assets such as stocks, bonds, and mutual funds, taxes on dividends from life insurance policies are deferred until their withdrawal, and are subjected to first in, first out treatment.  This is another unique and advantageous feature of life insurance which distinguishes it from other investment asset classes.