When looking into life insurance policies, it's important to get an understanding of the entire process, from how much the premiums are to taxes on life insurance benefits. When you are the recipient of death benefits from someone's life insurance policy, learning about what kind of taxes you owe are essential to the process.
Specific taxation regulations apply to life insurance policy death benefits, according to the Internal Revenue Code Section 101, which outlines the manner in which life insurance payouts can be taxed and when taxes on life insurance do not apply.
If you are the beneficiary for death benefits on a life insurance policy, the amount is not subject to income taxes. This means that any amount paid out to a beneficiary does not need to be included as income for taxable purposes. This privileged treatment under the law applies to most life insurance policies, regardless of the cash value or how long the policy was held. Many beneficiaries use permanent life insurance benefits to pay off estate taxes for a loved one.
However, if the insurance is in your name and the beneficiary is not your spouse, you may want to consult with a tax attorney. Your attorney may advise you to establish an irrevocable life insurance trust.
If you've set up a cash value policy, the amount is not subject to income taxes unless you take action and withdraw the money, effectively canceling the life insurance policy. At that point, any money that exceeds what you've paid in premiums will be taxed.
There are always exceptions to general rules when it comes to paying taxes on life insurance. Most life insurance policies are subject to premium limits, which mean that there is a set amount that can be contributed each year. This is to avoid life insurance policies from becoming build up too quickly and becoming tax-sheltered investment channels. For those policies that do allow large premiums to be deposited, the policy would be called a "modified endowment contract" and generally would not qualify for the tax protection offered to standard life insurance policies.
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