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  • What are the income-tax consequences for life insurance policies?
  • August 8, 2013
  • Tony Steuer

    By Tony Steuer, CLU, LA

    The value of a life insurance policy can impact a number of situations. For example, the possibility of a taxable gain if the policy is surrendered, which is often omitted in sales presentations.

    The inside interest is typically income tax deferred, which is either income-tax exempt or partially income tax exempt – depending upon how the policy terminates and the circumstance surrounding termination.

    There are four possibilities:

    There are four possible income-tax consequences for life insurance policies.

    #1

    The policy terminates upon the insured’s death. The death benefit is generally received income tax free by the beneficiary, so the inside interest is income-tax exempt.

    #2

    The policy is surrendered and the sum of the cash value and the total dividends are smaller than the total premiums; that is, there is a “loss” on surrender. Generally, the cash value is received income tax free by the policyholder, so the inside interest is income-tax exempt.

    The “loss” is not deductible, because the price of the protection exceeds the inside interest, and the price of the protection is not deductible – except to the extent it offsets what otherwise would be taxable as inside interest.

    #3

    The policy is surrendered and the sum of the cash value and total dividends is equal to the total premiums; that is, there is no “gain” or “loss” on surrender. Generally, the cash value is received is received income tax free by the policyholder, so the inside interest is income-tax exempt.

    In this instance, the price of protection and the inside interest is equal, so that the nondeductible price of the protection offsets the taxable inside interest.

    #4

    The policy is surrendered and the sum of the cash value and the total dividends is larger than the total premiums; that is, there is a “gain” on surrender. Generally, the “gain” is ordinary income to the policyholder in the year the policy is surrendered, so that the inside interest is partially taxable.

    The inside interest – which in this instance exceeds the price of the protection – is income-tax exempt to the extent of the price of the protection and taxable to the extent the inside interest exceeds the price of protection.

    Please note that this does not constitute tax advice and that we are not tax advisers.  Please consult your tax adviser as rates and exemptions are subject to change.

    (Source: The Insurance Forum; November 2001 issue, article excerpt; Dr. Joseph Belth.)

About Tony Steuer

Noted insurance author Tony Steuer has spent over 25 years in the life insurance industry. Steuer’s leadership roles include serving on the California Department of Insurance Curriculum board and the National Financial Educator's Council Curriculum Advisory Panel as well as having served as President of the San Francisco Chapter of the American Society of CLU & ChFC, President of the leading Life Insurance Producers of Northern California, and as a board member of the San Francisco Life Underwriters Association. Mr. Steuer is the author of Questions and Answers on Life Insurance: The Life Insurance Toolbook, The Questions and Answers on Life Insurance Workbook and The Questions and Answers on Disability Insurance Workbook - the first two were awarded the “Excellence in Financial Literacy (EIFLE) Award from the Institute of Financial Literacy. Steuer holds a Chartered Life Underwriter (CLU) designation and also holds the Life and Disability Insurance Analyst License, a designation that is held by less than thirty people in California.

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Questions & Answers on Life Insurance by Tony Steuer, CLU, LA, CPFFE is licensed under a Creative Commons Attribution 3.0 Unported License.

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