- How can I avoid tax penalties on insurance policies?
- June 29, 2010
Updated rules that govern how much money can be withdrawn at what time from cash-value life insurance policies could cause some unexpected problems for inattentive taxpayers, according to an Investopedia article
Author, Mark Cussen, says that the central point consumers should keep in mind when trying to avoid negative tax consequences while using cash-value life insurance policies as investment vehicles relies heavily on recent changes made by Congress.
Under the current rules, policies must pass the so-called “seven-year test,” which imposes a cumulative cap on the amount of money that can be paid into them during that time period.
If a policy doesn’t pass the seven-pay test, they receive a new classification of modified endowment contracts or MECs. This means that loans or withdrawals from an MEC are taxed on a “last-in-first-out” basis.
For example, a policyholder under the age of 59.5 would have to pay a 10 percent penalty for early withdrawal and be subject to guidelines set by the Internal Revenue Service.
Previously, Cussen writes, “policy owners could … withdraw both the interest and principal as a tax-free loan, as long as the policy did not lapse before the owner’s death. Of course, this strategy effectively allowed the policy to function as a large-scale tax shelter.”
In addition to life insurance-related rules, more general consumer financial regulations are coming into effect thanks to Congressional action, governing everything from credit cards, mortgage loans, and payday lending.
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