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How Is Life Insurance Taxed?

Because of the unique role life insurance plays in protecting people against the risk of economic loss, the federal government has extended favorable tax treatment to life insurance.

Premiums:

Generally, premiums paid for life insurance, whether paid by an individual or a corporation, are not tax deductible. In the case of return of premium term insurance, any premiums returned by the insurance company to the policyholder are received tax-free by the policyholder.

Living Benefits:

NOTE: The following discussion assumes that the life insurance contract meets the “seven-pay test” and is not classified as a modified endowment contract (see page 2 for information on modified endowment contracts).

Cash Value:

The cash value accumulations in cash value life insurance grow on a tax-free basis until the policy is surrendered. If the policy is surrendered and the proceeds exceed the total premiums paid, the difference is taxable in the year received.

Policy Dividends:

If a policy pays dividends, the dividends are considered a return of premium and are not taxable until total dividends plus all other amounts that have been received tax-free under the policy exceed an amount equal to the policyholder’s basis in the contract, at which time excess dividends are taxable income. Any interest on accumulated dividends, however, is taxable in the year credited.

Policy Loans/Withdrawals:

A policy loan is not considered a distribution and, as a result, is not taxable. If, however, there is an outstanding loan when the policy lapses or is cash surrendered, the amount of the outstanding loan is taxable to the extent that the policy's cash value exceeds the policyowner's investment in the contract. Cash withdrawals are tax free until the policyowner has recovered his/her investment in the contract, after which excess withdrawals are taxable income. Loans and withdrawals will reduce the policy's death benefit and cash value available for use.