One of the benefits of getting a whole life insurance policy is its built-in cash value account. This component works like a savings account, allowing the deposited money to grow on a tax-deferred basis. When you die, your beneficiaries get the face value plus the balance in the cash value account as proceeds. However, the cash value balance is subject to taxation under certain circumstances.
When you take out a policy loan, you are borrowing money from the cash value account. You get the funds on a tax-free basis and you’re not required to pay it back. However, if your policy lapses or gets canceled, the amount you haven’t paid back is now considered a capital gain. The outstanding balance of your policy loan is now subject to income taxes.
Modified Endowment Contract
If your whole life insurance policy is considered a Modified Endowment Contract, any distributions you get from your cash value account are subject to income taxes. Congress created the MEC designation to prevent policy owners from dumping money into their cash value accounts and taking advantage of tax-free withdrawals. Your policy becomes a MEC if you overpay your premiums during a seven-year test period. For example, if your premium payments are $500 per year and after the third year you paid $1,600, that is $100 more than the $1,500 you were supposed to pay, and your policy becomes a MEC. Once your policy is considered a MEC, it will always be a MEC.
Estate and Inheritance Taxes
If your policy is part of your estate at the time of your death, the amount payable to your beneficiaries is subject to federal estate taxes. As of 2012, up to 35 percent of your policy value can be taxed by the Internal Revenue Service. Several states also levies estate taxes. For example, Washington State taxes estates up to 19 percent. Beneficiaries may also have to pay inheritance taxes on the proceeds they got depending on where they live.
You can avoid state and federal estate taxes being levied against your policy. Assigning ownership of your policy to someone outside of your estate is an option. Another option is to name someone a beneficiary and not your estate. These changes must take place three years prior to your death or your policy will still be included as part of your estate. Generally states with inheritance tax laws don’t levy taxes on life insurance proceeds given to your linear family members such as your spouse, children and grandchildren.
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