Is Life Insurance Taxable?
Life insurance is complicated. Because of that, it might seem like tax could apply to life insurance policies too. However, it’s worth noting that the death benefit is not taxable. That is 100% tax-free regardless of how much it is, $10,000 to $10 Million. However, there are cases where a life insurance contract could lose its tax benefit status. In the case of a MEC, Modified Endowment Contract, you can be charged tax for the Death Benefit.
MEC – A modified endowment contract is a term given to a life insurance policy whose funding has exceeded federal tax law limits. In other words, the IRS does not consider this to be a life insurance contract anymore.” states Investopedia. There are limitations to what is taxable and what is not. So as previously mentioned it is always a good idea to consult your CPA.
How and Why do MECs exist? In a whole life or universal life policy, owners can pay additional money, over the premium, to grow cash value. This is beneficial for many reasons. In the past wealthy people sheltered their money in life insurance contracts. They still do, but life insurance contracts allowed too liberal of an investment-to-insurance ratio. So, for example, people could have a 100,000 life insurance policy and put millions of dollars into it. The government stopped that and created a ratio to maintain between the life insurance death benefit amount and the amount that could be contributed as savings per year, as a 7-year test. So they look at any given 7 year period to determine if you’ve invested too much. If you have, the contract forever becomes taxable as a “MEC” and loses many of the benefits that life insurance contracts would normally give you.
These days, insurance companies are very sensitive to this law and will double-check with you before allowing a policy to go into MEC status.
Are cash value loans tax-free?
Yes, there is no tax on borrowed funds. Loans are not considered income. However, if you pull money out as a withdrawal or distribution, there will be tax consequences on some of it. Any withdrawals up to your basis in the policy will be tax-free. Any withdrawals in excess of your basis will be taxed as ordinary income. The basis is the amount of premium you’ve paid into the policy less any dividends or withdrawals you’ve previously taken out. A CPA or the insurance company can help you know how much of your withdrawal is taxable. But we recommend using policy loans instead. Because you won’t have the tax burden and you won’t be affecting the future growth of your cash-value account of you take loans instead of withdrawals.
How to use a Cash Value Loan to your advantage
Cash-value loans can be used for anything you like. Many people use them as retirement income and just never pay it back. The heirs will be liable for it and the life insurance proceeds will be reduced by the loan balance. Other people use cash-value loans on many things and pay it back. Things like car loans, home loans, remodeling, swimming pool, virtually any large purchase. So, instead of taking out a loan for that hot tub or garage add-on, you could use a policy loan and then pay yourself back. Be your own bank!
Since this is a complicated topic, you should use the services of a licensed insurance agent familiar with how permanent life insurance works.