A life insurance policy can distribute money in two ways. If you die while insured, your policy will pay out a death benefit. Some permanent policies also grow cash value that you can take out and spend while alive. In both scenarios, the payout could be taxed or could be tax-free depending on how you managed the policy.
When your life insurance pays a death benefit, it will not be charged income tax. The Internal Revenue Service gives this tax break so your surviving heirs can better manage the financial costs of your death. Because of this tax benefit, people can't buy life insurance to make a profit off someone's death. You need to prove that you would suffer financially from a person dying before you can take a policy out on them. Typically, you can take a policy out on your spouse but not on your next-door neighbor.
While life insurance death benefits avoid the income tax, they aren't always tax-free. The IRS taxes large inheritances with the estate tax. As of 2012, you can give away up to $5 million worth of property tax-free after you die. If you give away more, anything over the limit gets hit with the 35 percent estate tax. If you own your life insurance policy when you die, the death benefit gets added to your estate and could be charged the estate tax. To avoid this tax, you need to change the owner of your policy to someone else. If you live for three years after the gift, the death benefit will be tax-free.
If your life insurance has cash value, the money is a combination of your premium payments and your investment gains. The way your money is invested depends on your policy. Whole life policies give a fixed rate of return on your money each year while variable policies invest your cash in the stock market. If you cancel your policy to take out your cash, you get your premiums back tax-free. However, your investment gains will be taxed as income.
There is a way to take out your cash value without paying taxes. You are allowed to borrow money from your insurance with a policy loan. The IRS doesn't tax these loans. The trick is that as long as you keep your policy active, you don't need to pay back the loan. When you die, the insurance company will take the unpaid loan out of your death benefit. Your heirs will receive whatever is left income tax-free. This means you were able to spend your investment gains without anyone ever paying income tax.
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