YOU ASK:

What are the basic principles of life insurance taxation?

WE ANSWER:

Although life insurance is generally assumed to be tax-free, there are a lot of small yet important details that you need to take into account when shopping for a life policy or making changes to an existing one. Here are some of the basic tax aspects of life insurance:

Life insurance proceeds paid to a designated beneficiary are not subject to federal income taxation. But if the proceeds are liquidated under a settlement option, the interest part is taxable as ordinary income. In order for the policy proceeds not to be subject to income tax, the policy needs to be transferred to a person who has an insurable interest in the insured's life, such as a partner of the insured, children of the insured or a corporation in which the insured is a shareholder.
Individual life policy premiums payments are not income-tax deductible. Exceptions are made for payment of group life insurance premiums provided to employees by their employers.
Dividends on life insurance policies are usually not income-taxable unless the sum of the dividends paid exceeds the total of premiums paid by the policyholder. If the interest is retained under the interest option, it is taxable. But if the dividends are used to purchase paid-up additions, the cash value that accumulates is not subject to taxation.
The increase in cash value in a permanent life policy is usually not subject to federal income tax. But if the policy is cashed in, the gain counts as ordinary income and is therefore taxable.
Policy loans are tax-free, even if they exceed the policyholder's policy cost basis.
The proceeds of a life insurance are included in the gross estate of the insured for federal estate tax purposes if the insured has had any ownership interest in the policy during the three years before death or at the time of death, or if the proceeds are payable to the estate. In order to remove the life insurance proceeds from the estate, the policy owner has to have made an absolute assignment to somebody else at least three years prior to the insured's death.
A federal estate tax is payable if the taxable estate exceeds certain limits. There is a tendency of the amount exempt from estate taxation to increase every year. For instance, in 2008 the exempt amount was $2,000,000, in 2009 it is going to jump to $3,500,000, and in 2010 it is expected that the estate tax will be repealed. Likewise, federal estate-tax rates have been decreasing proportionately.

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