Proceeds of a life insurance policy are usually received by a beneficiary tax-free. As Congress looks for ways to raise revenue, the tax-free status of life insurance may become a thing of the past. Several proposals have been made that would tax life insurance proceeds or tax the buildup of cash value inside a policy. Earnings within a policy are currently tax-deferred and can be borrowed from the policy tax-free. The cash value passes to the beneficiary at death as part of the death benefit escaping tax altogether. Many policy owners use the ability to borrow tax-free as way of paying the premiums in later years. Taxing the earnings inside a policy would require payments of taxes each year, in addition to making the premium payments.
Eliminating the tax-free status of life insurance would have a significant impact on insurance planning. A milder proposal gaining popularity is to require any transfer of a life insurance policy with a death benefit of at least $500,000 be reported. A policyholder must pay taxes on the difference between the value of the insurance proceeds and the amount paid for the policy. By requiring these transactions to be reported, the government hopes to eliminate transactions structured in a way that could avoid this tax.
Tax changes affecting life insurance like these have been proposed before and never enacted. It would be a serious blow to the insurance industry if life insurance ever lost its tax exempt status. Life insurance enjoys this status because the death benefit is compensating the beneficiary for the loss of life. The beneficiary has not gained anything and therefore no tax should be due. However, to the revenue starved government, no tax preferences are certain. It is therefore important to keep in mind the non-tax reasons that exist for purchasing life insurance, especially if the rules are modified.