3.8.7 Taxation of Life Insurance Products
Life insurance premiums are paid with after-tax dollars, but the earnings in the account can grow tax-deferred. If the policyholder decides to withdraw some of the cash value, the IRS uses a first in, first out assumption. The principal is assumed to be withdrawn first and the earnings last. Withdrawals of principal will not be taxed, but withdrawals of interest will be taxed at the policyholder’s ordinary income rate. Loans taken against the policy will have no tax consequences.
When the insured dies, the death benefit is included in the individual’s estate and is figured into the calculation of estate taxes. But the beneficiary does not have to pay any income taxes on the death benefit.
Note: The IRS treats withdrawals from life insurance products on a FIFO basis, but it treats withdrawals from annuities on a LIFO basis.
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SUMMARY TABLE |
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different kinds of insurance policies |
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Length of Coverage |
Premiums |
Death Benefit |
Cash Value of Policy |
Security? |
Used when? |
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Term Life Insurance |
Term of policy |
Fixed, but higher to extend policy |
Guaranteed amount |
None |
No |
Young person who wants money for spouse and kids, best value |
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Whole Life |
As long as premiums are paid |
Fixed |
Guaranteed amount |
Fixed, guaranteed minimum return that can be increased by dividends from the company |
No |
Wants death benefit, but also wants a savings vehicle |