Many people wonder if it’s possible for the government to tax life insurance. The basic answer to this is “no”, they cannot tax life insurance (although you can rest assured that the Congress tries to enact legislation that would allow it every year). However, it’s possible that money you get from your life insurance policy could lead into a taxable event.
Typically, if you receive a death benefit payment from a life insurance policy, that money comes to you tax-free. Every cent of it is yours and yours alone. Furthermore, if you have a cash-value-building life insurance policy like a Universal Life or a Whole Life policy, the money that accumulates inside that policy is all tax-sheltered.
However, there are some loopholes in these regulations that allow the government to dip its hand into your pocket when it comes to life insurance.
Cash-building life insurance policies have the possibility of eventually pushing up the ceiling on the death benefit, so that the death benefit when paid out is more than the face amount of the policy. If this happens, then all of the death benefit proceeds that you receive over and above the original face amount is considered taxable income when you receive it and must be reported. So, let’s say that someone had named you the beneficiary on a Variable Universal Life Policy that they took out for a face amount–the original death benefit amount–of $1,000,000. They have the policy for 30 years and they do quite well with the investment side of the policy, so that when they die you are paid $1.4 million. You must report the $400,000 on your income tax, but not the $1 million. The $400,000 is considered a withdrawal from the policy (the ultimate withdrawal!), and it’s possible for policy withdrawals (which of course can also be made by the insured while he’s still alive) to become taxable events. (But see below about how withdrawals are taxable.)
With cash-building life insurance policies, you never have to pay taxes on insurance company dividends given to you, for they are legally considered a return on premiums, and premiums are tax free. However, if you receive interest on your dividends, you do have to report them for tax purposes. If you take a withdrawal from your cash-building life insurance policy, if you exceed the total amount of premiums you have put in to that point, you have a taxable event on the amount you take out that is in excess of premiums. So, if you have paid $5,000 of premiums into a life insurance policy then take out $6,000 when there’s enough cash there for you to do so, you must report $1,000 on your income tax for the year that you took the money out. However, there is a way around this by taking advantage of life insurance companies’ loan-against-policy privileges. You’ll have to pay the money back with a very low interest rate, but this keeps you from being taxed.
With VUL insurance, you have actual investments inside the policy. These accumulate their money tax-sheltered. When money comes out of the policy and it’s not a loan, you have a possible taxable event. But, there’s more good news here: this taxation is done on a FIFO basis (first in, first out), meaning that you are considered to be taking out your input first. Whatever you put into the policy cannot be taxed (usually), only your gains can be. So this minimizes your taxable event. VUL policies are used more and more by financial planners to help their clients accumulate money for retirement while minimizing their taxes by capitalizing on the limited ability of the government to tax life insurance.