The Tax-Free Status of Life Insurance May be Changing
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The Tax-Free Status of Life Insurance May be Changing

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.