Life insurance provides a way for you to secure the financial future of your heirs after your death. Annuities allow you to establish an income that lasts throughout your retirement. Investors should not only understand the benefits of life insurance and annuities, but also how they are taxed. Income taxes reduce the return on your investment. Understanding tax laws regarding life insurance and annuities can help you develop a financial plan that saves you money in taxes.
Life insurance death benefits are typically exempt from income tax. Some life insurance policies give you the option to allow the insurance company to hold your death benefits and distribute the funds to your beneficiaries at a future date. While in holding, the funds can earn interest. If this occurs, the principal portion of death benefits is tax-free, but the interest portion is taxed as ordinary income.
Transfer for Value
Some life insurance owners trade their policies to another party for monetary value or consideration. The other party is typically named the beneficiary. The proceeds of the death benefit that represent a gain are taxable to the beneficiary. A transfer for value does not necessarily mean that the two parties exchanged cash. For example, a policy owner may agree to transfer value in exchange for property or services provided by the other party. The death benefit is tax-exempt if the owner gifts the policy to an individual or organization without receiving monetary value.
When you invest in an immediate annuity, you pay the principal up front to the insurance company in exchange for regular income payments for life. Immediate annuities do not include accumulation periods. If you pay the principal with after-tax dollars, the Internal Revenue Service considers a portion of your income payments as return of principal, and you must pay income tax on the other portion. The taxable portion is treated as ordinary income. A 10 percent additional tax penalty is assessed for withdrawals taken from your annuity before age 59 ½.
A deferred annuity includes an accumulation period in which your funds grow in a tax-deferred account. Unlike an immediate annuity, you contribute to the account over time. You must pay income tax when you withdraw funds at retirement. If you contributed to the annuity with pretax dollars, you must pay income tax on the total amount of your payments. If you contributed using after-tax dollars, you pay taxes only on the income considered earnings. You are required to pay ordinary income tax on any earnings above the amount of your initial investment if you receive a lump-sum payment by cashing out your annuity.
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