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How is Life Insurance Taxed?

Any smart person looking into obtaining life insurance will eventually ask the question how is life insurance taxed? Over the years, that question has become more and more difficult to answer because of the way that many life insurance policies have become investment vehicles. It's always a good idea to consult a competent professional on any financial matters but this article will give you some information so that you will have some general knowledge about the relationship between life insurance and taxes.

Many insurance policies today will take the premiums you pay and invest them in stocks, bonds, mutual funds, or other types of investments. With these investments the cash value of your policy can grow. But, the money earned on an insurance policy is generally tax-deferred meaning that no tax is due until the money is paid out or the policy is terminated. The tax-deferred earnings on an insurance policy can help the growth of the cash value of that policy a great deal. And if you need some cash but are worried about paying taxes on money you take out of your insurance policy, you can usually borrow money from your insurance policy and since borrowed money is not income you will not pay any income tax on that money. You will have to pay it back though.

But what about when the benefits are paid out, are the benefits subject to any taxes? When you pay your premiums on your life insurance policy the premiums are paid with after-tax dollars. Therefore, money that is paid out by your policy will generally be tax-free. For example, if you pass away and the beneficiaries named on the policy are your children, your children will not have to pay income tax on the money they receive from your life insurance policy. However, estate taxes may be applicable depending on the size of your estate and various other factors.

Life insurance policies can be used to creatively reduce estate taxes by a considerable amount. But estate taxes are a whole different subject and beyond the scope of this article. There are circumstances where taxes are applied to life insurance but when used correctly life insurance can greatly reduce the amount of taxes that you or the loved ones you leave behind have to pay.

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