A life insurance policy can make money in two different ways: First, you can die while insured and your heirs receive a death benefit. Second, you can buy a permanent policy that invests and grows your premiums. In both these cases, your life insurance money could be taxable or tax-free depending on your situation at the time.
Your death benefit is income tax-free to your heirs. The IRS gives this tax break because life insurance is designed to help people get over the loss of someone's death, not to make a profit. This is why there is a restriction on buying life insurance. You can only buy life insurance on a person whose death would affect you financially. You can buy insurance on your spouse but not on your neighbor across the street.
While your death benefit is income tax-free, it might result in estate tax. The IRS taxes large transfers of assets after a person dies. As of 2012, you can transfer up to $5 million worth of property and not owe any estate taxes. Anything over this limit will be taxed at the estate tax rate of 35 percent. This comes out of your estate before your heirs can collect their inheritance. When you die, your life insurance death benefit is added to the value of your estate. If it is over the estate tax limit, the money is taxable.
Your life insurance money, if tied up in a permanent policy, can be taxable during your life. Some permanent policies build up cash value that you can pull from while you are living. At the beginning, this money comes from your premium payments. However, the insurance company invests this money and it grows over time. If your account has more money than you paid in premiums, the investment gains are potentially taxable. They are tax-free as long as you keep your insurance active. If you cancel your policy, you will owe income tax on your investment gains.
There is a way to get around the income tax on your permanent policy's cash value. You are allowed to take out a loan from your cash value. The IRS doesn't tax loans. When you take out a loan, you never need to pay it back. If you die with an outstanding loan, the insurance company will deduct it from your death benefit. You won't owe any income tax for your loan and your heirs won't owe any income tax on the death benefit. You must keep your policy active to benefit from this approach.
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