Financial Planning

Life Insurance Series Part 4: Life Insurance Tax Features -What You Should Know.

Did you know that life insurance also offers a number of tax advantages?

As we discussed in Life Insurance Series Part 1, 2, and 3, the primary purpose of life insurance is to transfer risk, and provide financial security for families and businesses. But did you know that life insurance also offers a number of tax advantages?

Income Tax-Free Death Benefit

Generally, your beneficiaries will pay no income tax on the death benefits they receive from your life insurance policy, with one caveat. If the policy transferred from one owner to another, it can trigger the transfer-for-value rule and may forfeit its tax-exempt status. Most commonly, this happens when a policy is transferred between stockholders to fund a buy-sell agreement. There are, however, five exceptions to the transfer-for-value rule that allow you to retain the tax-free death benefit:

  1. Transfer to the insured on the policy
  2. Transfer to the partner of the insured (but not to a co-stockholder)
  3. Transfer to a partnership in which the insured is a partner
  4. Transfer to a corporation in which the insured is a stockholder or officer
  5. Transfer in which the recipient’s basis is determined by the basis of the transferrer (e.g., a gift)

Keep in mind that, although life insurance is generally income tax-free, it is not necessarily estate tax-free. The taxable value of life insurance in your estate is based on the death benefit. If you transfer life insurance to an irrevocable trust or to another person, it is not included in your taxable estate once three years have elapsed after the transfer. Note, however, that a transfer of life insurance may trigger gift taxes.

Tax-Deferred Growth of Policy Cash Values

As interest and dividends are added to the cash value of your life insurance policy, the increases are generally not subject to taxes until you surrender the policy. Some types of life insurance, such as whole life policies, pay dividends to the policy-owner. These are not dividends in the usual investment sense, but instead are considered a return of a portion of your annual premium.

Dividends from whole life insurance can be used to reduce premiums or to buy additional insurance, neither of which triggers taxes. Likewise, dividends taken as cash are not taxable unless the amount of the dividend exceeds the premiums paid. Dividends reinvested to “accumulate at interest,” on the other hand, are an exception to the tax-deferred growth rule. In this case, the interest earned on the dividends is taxable each year.

Unlike whole life insurance, universal life policies do not produce dividends. With these policies, interest is applied to the cash values without an immediate income tax impact.

In addition, you can change the type of life insurance product, or your insurance carrier, without triggering a taxable gain. A Section 1035 exchange permits the policy-owner to transfer the cash value of an existing policy to a newly issued one. You can also transfer life insurance cash values to an annuity tax-free.

Tax-Advantaged Withdrawals From Policy Cash Values

Another benefit of life insurance is that it allows you to withdraw your tax basis from your policy before recognizing any gain. This is also referred to as FIFO (First-in, First-out). A gain is defined as the amount that the cash value exceeds the premiums paid into the policy. Premiums for some riders do not qualify as basis, and dividends received in cash generally reduce your basis.

Policy loans: You can also access your cash values through policy loans, which offer several potential advantages:

  • You do not have to qualify financially for a policy loan
  • You can elect to defer interest and principal repayments
  • If you die before repaying the loan, it is repaid from your death benefit

Although policy loans are an attractive benefit, you should not take one without careful planning. Cash values and death benefits will be reduced if loans are outstanding at the death of the insured. When you take a policy loan, you are borrowing from the insurance company’s general fund and putting up your policy’s cash value as collateral.

If you elect to defer your loan interest, it will be added to the next year’s loan principal. If unwatched, your loan may exceed the policy’s maximum collateral limit. At that time, if you choose not to make a repayment, the insurance company will recover the amount due from your cash values, potentially resulting in termination of your life insurance. At the lapse of your policy, all taxes on the deferred policy gain are due.

If you plan to use your policy cash values to supplement your retirement, be sure to understand the loan management options your policy offers. To help manage policy lapses caused by loans, some companies offer a feature known as “overloan protection.”

Making the Most of Life Insurance Tax Benefits

Of course, there are limits to the amount you can invest in life insurance policies. To discourage abuse of life insurance as a tax shelter, Congress has enacted certain premium limits. The premium limits differ with each type of policy, the amount of the death benefit, and the policy features. An insurance professional can discuss these limits with you and help ensure that you reap the maximum tax benefits from your life insurance policy.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

Kelsey Dolfi, CPA. RiverStone Private Wealth Advisors, 7 Livingston St. Rhinebeck, NY 12572. 845-516-4440. Securities offered through Commonwealth Financial Network, Member FINRA/SIPC.

Kelsey is a Wealth Planning Advisor and Certified Public Accountant at Marshall & Sterling Wealth Advisors, located in the New York tri-state area. Kelsey enjoys working with those who feel they find themselves juggling various financial goals and they aren’t sure where to put their money first. Whether it’s saving for their children’s education, maximizing corporate benefits large corporations, or wanting to know if they can afford that dream upstate house, she helps them pull the pieces together into a clear path to success. Kelsey has an MBA and B.S in Accounting from Alfred University. She also holds her Series 7 with LPL Financial, Series 66 with LPL Financial and Marshall & Sterling Wealth Advisors , and New York life insurance and annuity license. Prior to working in wealth management, she worked as an auditor in both the public and private accounting industries. In her free time she enjoys running and exercising, reading, and she is an enthusiastic supporter of local businesses, specifically in the Hudson Valley. She can be reached at reached at or 845-554-1046 x2353. You can read more about Kelsey and Marshall & Sterling Wealth Advisors at

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