Paid-Up Capital In Life Insurance: Taxable Or Not?

Life insurance is often seen as a way to provide for loved ones after death, and one of its biggest advantages is the tax relief it offers. Generally, life insurance proceeds are not considered taxable income, but there are some exceptions. One such exception is additional paid-up capital in life insurance, which can impact the tax status of the policy. This paragraph aims to introduce the topic and provide an overview of the relevant considerations for understanding the tax implications of additional paid-up capital in life insurance.

Interest on life insurance proceeds is taxable

Life insurance proceeds are generally not taxable if you receive them as a beneficiary following the insured person's death. However, any interest accrued on those proceeds is taxable and must be reported. This means that if you opt to receive the life insurance payout in instalments instead of a lump sum, the interest accumulated on those instalment payments is taxed as regular income.

The interest is reported as interest received, and you can refer to Topic 403 for more information. Additionally, if the policy was transferred to you in exchange for cash or other valuable consideration, the exclusion for the proceeds may be limited to the sum of the consideration paid, additional premiums paid, and certain other amounts.

It is important to note that the rules may vary based on your location and specific circumstances. Consult a tax professional or refer to official government sources for specific guidance on tax obligations related to life insurance proceeds and interest.

Life insurance death benefits are tax-free

Life insurance death benefits are typically tax-free, but there are a few exceptions where taxes may be incurred.

Lump Sum vs Installments

If the beneficiary receives the death benefit in a lump sum, it is generally tax-free. However, if they choose to receive the payout in installments, any interest that accumulates on those payments will be taxed as regular income.

Policyholder vs Estate

If the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, the estate's total value may trigger estate taxes, reducing what the beneficiaries ultimately receive.

Policy Loans

In the case of cash value life insurance, policyholders can borrow or withdraw money from the policy's cash value. If there are unpaid loans against the policy when the policyholder dies, they will be deducted from the death benefit, reducing the amount received by the beneficiaries.

Modified Endowment Contracts (MECs)

If the policy is a Modified Endowment Contract (MEC), withdrawals are taxed differently. Withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

Employer-Paid Group Life Plans

In some cases, an employer-paid group life plan that pays out more than $50,000 may be taxable, according to the Internal Revenue Service (IRS).

Estate Taxes

If the death benefit and the total value of the deceased's estate exceed the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. As of 2023, the threshold was $12.92 million.

Whole life insurance and taxes

Whole life insurance is a form of permanent life insurance that provides coverage for your entire life, as long as you keep up with your payments. It also has a cash value component that can be used during your lifetime. This cash value increases each year, either according to a schedule guaranteed by the insurance company or through annual dividend payments, if you buy the policy from a mutual whole life insurance company.

Tax Advantages of Whole Life Insurance

Whole life insurance offers several tax advantages:

• Tax-deferred growth: The cash value of your policy grows tax-free, allowing your money to grow faster as it is not reduced by taxes each year.
• Income-tax-free death benefit: The money your beneficiaries receive after your death is generally not subject to income taxes, providing them with a guaranteed sum of money.
• Tax-free loans and withdrawals: You can take out loans or make withdrawals from the cash value of your policy without immediate tax consequences, as long as they are structured properly. However, if you don't repay the loan, it will be deducted from the death benefit paid to your beneficiaries.
• Tax-free dividends: Dividends paid by the insurance company are generally not taxable, depending on the stage the cash value has reached.

Tax Implications of Whole Life Insurance

While whole life insurance offers tax benefits, there are also some tax implications to consider:

• Interest on dividends: While dividends themselves are not taxed, any interest earned on those dividends is considered taxable income and must be reported.
• Federal estate taxation: The money your beneficiaries receive may be subject to federal estate taxation if your estate exceeds the exemption limit.
• State taxes: State inheritance taxes and federal gift taxes may apply to life insurance policies and proceeds under specific circumstances.
• Tax consequences of cashing out: If you surrender your policy, any amount received above your cost basis (the total premiums paid) may be subject to income tax.
• Tax consequences of borrowing: If you borrow against your policy and don't repay the loan, it will be treated as a withdrawal and may be subject to income tax if it exceeds your cost basis.

Life insurance premiums and tax deductions

Life insurance premiums are generally not tax-deductible. The IRS considers them personal expenses, and they are therefore ineligible for tax deductions. However, there are some exceptions to this rule.

• Business owners offering group life insurance to employees: Owners of certain types of businesses, including LLCs and S corporations, can deduct premium payments they make for their employees. However, the business owner or company cannot be the policy's beneficiary, and the coverage offered cannot exceed $50,000.
• Donating your policy to charity: Transferring ownership of your life insurance policy to a charitable organisation can provide a tax benefit. When you gift your policy to a qualifying charity, the premiums you paid into the policy, as well as premiums paid after the transfer, may be tax-deductible.
• Older alimony agreements: Spouses required to buy life insurance as part of an alimony agreement made prior to 2019 may qualify for a tax deduction on their premiums. However, due to tax code changes, tax deductions for alimony payments are no longer allowed for life insurance premiums as of 2019 and beyond.

Life insurance death benefits are typically income tax-free. However, if a beneficiary chooses to receive the death benefit in installments, they may generate some taxable income on amounts that exceed the death proceeds. Additionally, life insurance proceeds are considered part of a beneficiary's taxable estate, so they could be subject to estate tax if the amount exceeds their remaining lifetime exclusion at the time of the policy owner's death.

Life insurance dividends and taxes

Life insurance dividends are a sum of money that an insurer pays to each policyholder based on the company's profits. Permanent life insurance policies, such as whole life insurance, generally pay dividends since they have a cash value. Term life insurance does not pay dividends. Insurers usually pay dividends annually, and they are separate from cash value earnings.

Life insurance dividends are typically not taxable. This is because the IRS considers a life insurance dividend to be a return of premiums paid. However, there are exceptions.

When Life Insurance Dividends Are Taxable

• Dividends exceed the total premiums paid: If the dividends you receive are greater than the total premiums paid into the policy, the excess may be taxable because it is considered income, not a return of premium.
• Earning interest on dividends: If you leave your dividends in your policy to earn interest, this interest income may be taxable if it is more than the premiums you have paid.

Using Life Insurance Dividends

Policyholders can choose to receive their dividends in several ways:

• Cash: Many people choose to receive their dividends in cash, which can supplement income or be used for a specific purpose.
• Future premium payments: Dividends can be applied to future premium payments, reducing the cost of coverage and ensuring it doesn't lapse due to financial problems.
• Accumulating interest: Leaving dividends in the policy to accumulate interest allows the principal to grow faster, resulting in larger interest payments and quicker growth of cash value.
• Paid-up additional life insurance: You can use your dividends to purchase additional paid-up life insurance, increasing your coverage without raising your premiums.
• Reduced paid-up policy: Purchasing a reduced paid-up policy with your dividends allows you to stop paying premiums but requires lowering your death benefit.

Avoiding Life Insurance Taxes

While life insurance policies offer tax advantages, careful planning can help mitigate potential tax liabilities:

• Choose a lump-sum payout: Opting for a lump-sum death benefit payout keeps it tax-free and avoids taxable interest on installments.
• Avoid the Goodman Triangle: In this scenario, the IRS may view the death benefit as a gift, triggering a gift tax. To avoid this, ensure only two parties are involved in the policy.
• Use an irrevocable life insurance trust (ILIT): Transferring the policy to an ILIT at least three years before death keeps the death benefit out of your taxable estate.
• Manage policy loans: Monitor loan balances and ensure the policy doesn't lapse to prevent taxable income from policy loans.
• Transfer ownership early: Transferring policy ownership well in advance keeps it out of your taxable estate.
• Regularly review beneficiaries: Ensure your estate isn't named as the beneficiary to prevent estate taxes, and name a contingent beneficiary.

Frequently asked questions