4.3 Tax Treatment of Proceeds
When an insured dies, proceeds of a life insurance policy paid as a lump sum death benefit to a beneficiary are exempt from federal income tax. A taxable event can be avoided when canceling one insurance product and depositing the funds in another with the use of an IRS Section 1035 form. 1035 contract exchanges are allowed if:
- a life insurance policy is exchanged for another life insurance policy, endowment policy or annuity contract;
- an endowment policy is exchanged for an annuity contract; or
- an annuity contract is exchanged for another annuity contract.*
*An annuity contract cannot be exchanged tax free for a life insurance contract. This is not an acceptable exchange under Section 1035. (More on 1035 contract exchanges is presented in Lesson 4.3.2.)
Since most life insurance premiums are considered personal expenses, the premiums are not deductible. Premiums paid by a business are not deductible as well; however, there are a few exceptions.
- Premiums paid for life insurance owned by a qualified charitable organization are deductible.
- Premiums paid for life insurance by an ex-spouse as part of an alimony decree are deductible (as alimony).
- Premiums paid by a business creditor for life insurance purchased as collateral security for a debt are deductible.
- Premiums paid by an employer for employee group life insurance are deductible as an employee benefit business expense, as long as certain conditions are met.
Cash Values
As long as the equity remains in the policy and continues to accumulate, the cash value remains tax free. Once it is surrendered however, the equity is considered taxable income.
Whenever a policy terminates for any reason other than a death benefit, any excess income over the cost basis is taxable.
Remember that money is taxable only once - the same money cannot be taxed twice. That's a good rule of thumb to keep in mind when considering what portion is taxable and what is not. The premiums that go into the policy have already been taxed (for instance, through your paycheck). However, the interest those "taxed funds" earns through investments has not been taxed yet. You can consider that interest as just sitting there (sheltered) waiting to come out. And when it does, it will be taxed.
What happens when the money is taken out while the insured is still living, such as for retirement income?
In that case, the portion that is paid out is considered a "return of principal" (the principal being the money originally put in, i.e., through your paycheck with after-tax dollars) and is not taxable (because remember it was already taxed). This part of the principal was paid with after-tax dollars.
