Life insurance can be the most important purchase a person will make in their life. (Life insurance is defined as the contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money upon the death of the insured person.) It can help protect the insured person’s family from excessive costs that may pile up after his/her death, finance children’s education, allow to continue a business or replace lost income. What a lot of people don’t know is that life insurance also may accumulate cash value and offers some tax advantages, which I will describe below.
1. An insured person’s beneficiary (a person who receives proceeds from the life insurance policy) does not pay any federal income tax on death benefits received. So, a beneficiary will obtain the full amount of $250,000 from a $250,000 insurance policy. The IRS does not require any deductions or withholding from beneficiary’s proceeds. In fact, the benefits received are not included in the calculation of their gross income and do not have to be reported.
2. If an insured person transfers the ownership of their life insurance policy to another person, they will avoid paying estate taxes on life insurance death benefits. In order for that to happen, the transfer must take place three years prior to an insured person’s death.
Side note: according to the IRS, “The Estate Tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death. The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets. Once you have accounted for the Gross Estate, certain deductions (and in special circumstances, reductions to value) are allowed in arriving at your Taxable Estate. A filing is required for estates with combined gross assets and prior taxable gifts exceeding $5,250,000 in 2013.” Therefore, only those people who leave behind over 5 million dollars need to worry about the estate tax.
3. Finally, a life insurance policy that can accumulate cash benefits for it’s owner is called permanent insurance and generally provides coverage for the duration of the insured person’s life. The premium amount remains the same for the life of the policy, and accumulates cash value. This cash value is available to the insured through policy loans. As the cash value builds up, the insured does not have to pay any current federal income tax. In addition, after a big enough amount of cash value has accumulated, the insured can borrow from it to supplement their retirement income.
In my next blog post I will talk about capital losses and how the IRS can help you reduce the financial burden through tax breaks. This might be one of the main reasons to remain in the stock market and recoup your losses faster.