In this section I’d like to look at a perhaps lesser thought of detail when it comes to purchasing life insurance. That detail is income taxes. You probably already know that getting a life insurance policy may be pretty simple for a lot of people. All they have to do is to find a reliable insurance company and file an application. Once approved, the policy owner simply pays the monthly premium amount stipulated in the policy that he/she has chosen.
However, doing it right is really not as easy as it may appear to be. Like any legal document, a life insurance policy is executed under certain laws and must conform to the regulations stated in the policy provisions.
One of the legal concerns of life insurance policies are taxes, both state and federal. Therefore, it is important that the policyholder know the basic concept of taxes as applied to his/her life insurance policies.
To know more about the tax regulations, where life insurance policies are concerned, here are some pointers that you will want to know. However, these ideas should not be regarded as applicable in every life insurance policy. These are general concepts regarding the way that taxes apply to life insurance policies in general.
Keep in mind that not all life insurance policies are created equal. Therefore, it would be in your best interest to consult your tax lawyer, accountant or independent insurance agent, as to the particular regulations that apply to the type of policy that you are considering purchasing.
Here are some points to consider:
- Life insurance gets privileged treatment under the tax regulations
As provided in Section 101 of the “Internal Revenue Code,” the incomes generated from a life insurance policy, which has been stipulated in the policy as a “death claim” and is subject to the exemptions as stated in the regulation, are not considered to be taxable income, when disbursed. This may well be a big reason that the insurance industry continues to grow.
- Certain types of life insurance are granted a particular tax advantage
Certain life insurance policies, such as permanent life insurance, are granted preferred tax treatment. According to the provisions of the Internal Revenue Code, policyholders, as well as their beneficiaries, are not required to pay any taxes, on any profits, in the permanent life insurance policy, provided that the policy remains in effect.
This privilege is commonly known as “cash value growth.” However, the regulations require that the policyholder, as well as his/her beneficiary, conform to some “premium limits” in order for the permanent life insurance policy to not be considered as a “modified endowment contract.”
- Modified endowment contracts
In the case of modified endowment contracts, the tax treatment of those life insurance policies is entirely different. A modified endowment contract or MEC is classified as any other “permanent policy” that falls short in the “seven pay-test”, as stipulated in the Internal Revenue Code 7702A.
When it comes to these policies, the government has decided that modified endowment contracts be considered a particular class of life insurance and be accountable to specific tax regulations.
Modified endowment contracts are still considered as life insurance policies, but the government regards them as if they were actually “investments”, because of the emphasis on the tax-suspended accumulation of “cash values.”
In other words, the government had concluded that if “cash values” build up too quickly in a particular life insurance policy, it may be regarded more as an investment channel, rather than security against an untimely death.
Accordingly, modified endowment contracts may still enjoy some tax advantages but not entirely the same as typical life insurance policies. One of the main disadvantages of getting a modified endowment contract is its 10% federal fine, for premature withdrawal before the age of 59½.
- Law defines any policy loan as non-taxable income
One of the greatest and most favorable tax benefits of life insurance is that as a policy loan, any amount of money generated from a life insurance policy is not considered as taxable income.
Moreover, all of the withdrawals from the policy can be obtained, up to the sum of disbursed premiums, without being subject to any kind of tax.
Given all these facts, life insurance policies may be enjoying advantageous tax treatment, but it is still necessary for every individual to consider the possible problems that may caused by these provisions. That is why it is important to always consult experts and do some research regarding money matters before committing to such contracts.
Your independent insurance agent would be your best first contact. Once he/she has given you all the appropriate information and found you the best possible coverage for the best possible price, if you still had tax questions, that would be the time to incurr the added expense of talking to a tax lawyer or accountant.