When you get a distribution from a whole life policy, the money could be taxable. The Internal Revenue service can charge tax when a whole life policy pays a death benefit and when it pays out cash value. However, there are ways to avoid the tax implications in both situations. You just have to plan your finances ahead of time.
Many whole life policies build up cash value. This is money that you can take out of your account and spend while you are alive. Your cash value initially comes from your premium payments. However, over time the insurance company invests your money and your cash value grows. If you cancel your policy to take out your cash, the IRS taxes your investment gains as income. You get your premium payments back tax-free, but if you receive more than you paid into the policy, you'll owe taxes on the gains.
There is a way to get your cash value without paying taxes. Instead of cancelling your policy, you can also take out your money with a loan. The IRS doesn't tax life insurance loans. As long as you keep your policy active, you never need to pay your loan back. If you die with an outstanding loan, the insurance company just deducts the loan from your death benefit. Whatever is left over goes to your heirs. This lets you spend your investment gains without paying income tax.
When your heirs receive your whole life policy death benefit, they will not owe any income tax. The IRS makes life insurance death benefits income tax-free because they are meant to cover the financial loss of a person's death. This tax benefit is the reason you can't buy life insurance on someone purely as an investment. You need to show that you would suffer financially from a person's death. You can buy insurance on a family member, but not a complete stranger.
While a whole life policy death benefit is income-tax free, it could still be taxed. If you own your life insurance policy when you die, the death benefit is added to your estate. The IRS taxes large inheritances with the estate tax. As of 2012, you can transfer $5 million to your heirs tax-free. Anything over this limit, including your life insurance death benefit, will be charged the 35 percent estate tax. To get around this tax, you can make someone else the owner of your life insurance policy. This way it won't be part of your estate and will avoid taxes. You must live at least three years after the transfer or the death benefit will still be included in your estate.
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