The prospect of providing financial security for your loved ones in the event of your death is the primary draw of life insurance, but it can also be a good investment vehicle. Several types of life insurance coverages are available. Some are bought privately or through group-sponsored plans. The types of plan you purchase as well as other factors determine whether your beneficiaries receive benefit payments tax-free.
Benefits From Private Life Insurance
Private life insurance policies consist of two types of coverages: term and permanent. Term life plans provide only death benefit payments. Permanent life insurance plans, such as whole life and universal life, provide cash value accounts, which you can borrow from, along with death benefit payments. These plans generally are bought from insurance companies. Premiums for private life insurance policies are paid with after-tax dollars. Therefore, your beneficiaries receive the life insurance payouts tax-free.
Benefits from Group Life Insurance
You may be able to obtain group life insurance coverage through your employer. Life insurance may also be obtained through your trade association or other member organization to which you belong if they sponsor group coverage. Insurance premiums for group life coverage are paid for by plan sponsors. Benefit payments are not taxed up to a certain limit. According to the Internal Revenue Service, group life insurance benefit payments are not taxable up to $50,000. Amounts over this limit are considered taxable compensation. Benefit payments from group life insurance coverage on spouses or dependent children are not taxable up to $2,000.
Benefits from a Modified Endowment Contract
Your life insurance benefit payments are taxable if you overpay premiums within a certain timeframe. The IRS considers your life insurance policy a Modified Endowment Contract (MEC) if, during the first seven years of the policy’s existence, you paid more in premiums than required. For example, if your premium payments are $300 per year and the third year of the seven-year test period, you pay $301 or more, your plan becomes a MEC. You can overpay premiums and avoid your policy becoming a MEC if you’re catching up. Using the example above, if during year two you paid $299 or less in premiums, you can overpay in subsequent years only to become current. The seven-year test period applies to all life insurance policies entered into after June 20, 1988. Policies entered into before June 21, 1988 are tested only if there are material changes to coverages or benefit amounts are reduced.
If your life insurance policy is scheduled to pay out a tax-free benefit, the IRS may still tax the proceeds depending on the value of your estate. If your estate’s value, including the face value of your life insurance policy, exceeds the IRS’s limit of $5,000,000 as of the time of publication, your benefit amount becomes taxable. To avoid estate taxes on your life insurance policy, you must name the beneficiary and policy ownership outside of your estate. These changes must be completed more than three years prior to your death.