Co-Founder, Coastal Financial Partners Group, California
Generally, none if proper steps are taken. Life insurance death benefit proceeds received by a beneficiary are income tax-free in most cases. This is a key feature of life insurance.
Common exceptions include business-owned life insurance issued, or materially modified, after August 17, 2006 which may be taxable unless specific steps are taken during time of application and annually thereafter to meet conditions which allow the proceeds to be income tax-free. Another exception is a tax trap where life insurance contracts with three parties involved may also have unexpected taxable implications.
Beyond the death benefit tax-free characteristics, the cash values have important tax aspects as well. Cash value builds free of tax.
If the policy-owner accesses cash values via withdrawals of some of the cash value (after policy year 15), the amounts are income tax-free return of basis (premiums paid) in the contract. After that, the gain would be income taxable. Special tax rules exist for distributions in the first 15 policy years.
If the policy-owner accesses cash values by taking a policy loan, the amounts would be income tax-free. As long as the policy is not lapsed prior to the net death benefit being paid, the policy loans are never taxed. If there is a large loan and the policy is allowed to lapse, income tax would be due that year on all of the gain in the contract.
In the event of a full surrender of the policy for its cash value, there would be income tax to the extent of gain in the contract.
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Common exceptions include business-owned life insurance issued, or materially modified, after August 17, 2006 which may be taxable unless specific steps are taken during time of application and annually thereafter to meet conditions which allow the proceeds to be income tax-free. Another exception is a tax trap where life insurance contracts with three parties involved may also have unexpected taxable implications.
Beyond the death benefit tax-free characteristics, the cash values have important tax aspects as well. Cash value builds free of tax.
If the policy-owner accesses cash values via withdrawals of some of the cash value (after policy year 15), the amounts are income tax-free return of basis (premiums paid) in the contract. After that, the gain would be income taxable. Special tax rules exist for distributions in the first 15 policy years.
If the policy-owner accesses cash values by taking a policy loan, the amounts would be income tax-free. As long as the policy is not lapsed prior to the net death benefit being paid, the policy loans are never taxed. If there is a large loan and the policy is allowed to lapse, income tax would be due that year on all of the gain in the contract.
In the event of a full surrender of the policy for its cash value, there would be income tax to the extent of gain in the contract.