Life insurance is not meant to be used as an investment, rather to replace a financial loss. It can’t be purchased on just anyone; there must be a legitimate reason of financial suffering should the insured die. Therefore, the Internal Revenue Code doesn’t subject a death benefit to income or capital gains tax.
Unlike a death benefit, life insurance cash value is taxed like a qualified retirement plan. As long as the money stays in the life insurance, there is no tax on the gains. However, if the gains are taken out during the life of the insured, they are taxed as ordinary income, not as capital gains.
One way to avoid paying tax on money taken from a life insurance policy is to take it as a loan from the cash value. It is then tax-free, as the IRS taxes withdrawals not loans. Given certain circumstances, this can be a source of funds, which would never need to be paid back. When the insured dies, the life insurance policy will pay the loan, along with accrued interest, out of the insurance death benefit. The caveat? The policy must remain active for the rest of the insured’s life! If the policy is cancelled or lapsed, the loan counts as a withdraw and will then be subject to taxes on the gains in the year it ceases. And, as noted above, it would not be taxed at the preferred capital gains tax, rather it would be taxed at the taxpayer’s ordinary income tax rates.
While life insurance death benefits avoid income and capital gains tax, it is not always tax-free. When a person dies, everything owned, including the life insurance death benefit value, is considered a part of the estate. If the estate exceeds the federal estate and gift tax exemption, $5.45 million per individual in 2016, the death benefits are subject to federal estate tax.
Benjamin Franklin wrote in a 1789 letter, “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” If only he knew how his observation on death and taxes lives true still today, 227 years later!
- Written by Pamela Smitson, CPA, Worley Erhart-Graves Financial Advisors