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Money invested in a life insurance policy is not usually subject to federal income taxes until it is taken out or paid out. The taxation of life insurance funds depends upon how the money is taken out and who gets it.
Funds invested in Life Insurance Policies
The IRS treats the funds in most life insurance policies as tax-deferred retirement investments. That means that federal income tax is not paid on them until they are taken out. As long as the funds remain in the policy they are not taxed. If money is withdrawn early it will be subject to income tax at the normal rate.
In some cases funds taken out a life insurance policy could be subject the 10% tax penalty charged on early withdrawals of retirement funds. Persons who take funds out of retirement policies before they reach age 59½ are usually subject to this penalty.
That means a person could use life insurance policies as a tax-deferred benefit. It would more advisable to use such policies insurance and utilize vehicles such as IRAs or annuities as an investment.
Taxes on Life Insurance Benefits
In most cases a life policy’s death benefits are exempt from income tax. That means beneficiaries will not have to pay federal income taxes on the money they receive. There are some exceptions to this rule that you should be aware of.
If the life insurance policy is part of an employer’s benefits package any death benefits over $50,000 are regarded as taxable income by the IRS. These benefits are taxable because the IRS regards them as fringe benefits rather than insurance. This applies to group term and other policies that employers may purchase for employees. Death benefits from life insurance policies purchased by private individuals are not considered taxable income by the IRS. From a tax standpoint it would be better to purchase life insurance yourself than receive it from your employer as a benefit.
The rules would affect Mrs. Smith this way if she died and received benefits from her husband’s insurance policies. Mrs. Smith would not have to declare any money from an insurance policy she and her husband purchased. On the other hand she would have to declare an extra $50,000 if her husband had a $100,000 group-term life insurance policy as part of his benefits package.
This is why many people use life-insurance to get around taxes. It is a good way to transfer wealth to loved ones without incurring tax penalties. High-income individuals should consult a tax professional or probate attorney before following this strategy.
State Taxes and Life Insurance
Taxes on both life insurance policies and benefits vary from state to state. You should consult your state tax authority or a tax professional to see exactly how state taxes will affect your life insurance policy. Insurance policies and benefits could be subject to state income and capitol gains tax.
There are also some states such as Texas where the sales tax applies to services as well as goods. That means life insurance premiums could be subject to the state sales tax. If there is sales tax on your insurance premiums you should be able to deduct it from your federal income tax return.
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