There are two ways to make money off life insurance. If you own a policy on someone and he dies, you collect the policy death benefit. You also can buy a policy that grows cash value, money that you can take out while you are alive. In both scenarios, your gains could be taxed. However, they will never be taxed as capital gains.
When your policy has cash value, you will earn money on your cash. Whole life policies give a fixed return on your account, while variable policies let you invest your money in the stock market. Life insurance cash value is taxed like a qualified retirement plan. As long as the money stays in the life insurance, you don't owe any tax on the gains. However, when you take your gains out, they are taxed as regular income, not as capital gains.
There is a way to take out your cash value gains without ever paying any taxes: You are allowed to take a loan out from your cash value. This is tax-free as the IRS taxes withdrawals, not loans. The trick is you don't need to pay your loan back. When you die, the life insurance policy will pay the loan out of your insurance death benefit. You just need to keep your policy active for the rest of your life. If you cancel your policy, your loan counts as a withdrawal and you'll then owe taxes on your gains.
Life Insurance is not meant to be used as an investment or for speculation. You can't buy insurance on your neighbor because you think he looks sick and there is a good chance you will make money off insuring his life. To buy insurance on someone, you need to show that you will suffer financially if she dies. Since a death benefit is used to replace a financial loss, the IRS doesn't charge income tax or capital gains taxes when you receive a death benefit payout.
While a life insurance death benefit avoids income and capital gains taxes, it is not always tax-free. When a person dies, everything he owns is considered his estate. This includes the value of any life insurance death benefits. As of 2012, a person is allowed to transfer up to $5 million tax-free at death. If the person transfers more than $5 million, anything over the limit is charged the 35 percent estate tax. This tax could reduce your life insurance payout.
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