Life insurance policies offer several tax benefits.
- Tax-Exempt Death Benefits: The death benefit paid out on a life insurance policy is generally received by the beneficiary free of income tax.
- Tax Deferral on Cash Value Build-Up: The cash value that accumulates within a life insurance policy is not taxed as it accrues. This “inside build-up” is tax-deferred and can be a significant advantage, as it allows the policyholder to accumulate wealth within the policy without immediate tax consequences.
- Policy Loans: Loans taken against the cash value of a life insurance policy are considered true loans for federal income tax purposes. The proceeds from these loans are not taxable, and using the policy’s proceeds to satisfy the loans has the same effect as paying the proceeds directly to the policyholder.
- Interest Deductibility: Historically, interest on loans taken against the cash value of life insurance policies was deductible, creating opportunities for tax arbitrage. However, Congress has imposed restrictions on this benefit over time.
- Split-Dollar Life Insurance Arrangements: These arrangements can be used for estate planning to remove death benefits from taxable estates or defer tax payments. The cash value build-up in such policies is not taxed as it accrues, making them attractive for long-term tax-advantaged savings.
- Corporate-Owned Life Insurance (COLI): Corporations often use life insurance policies on key employees as investment vehicles due to the favorable tax treatment of death benefits and inside build-up. These policies can also be used to fund deferred compensation and other employee benefit plans.
These benefits make life insurance policies a versatile tool for both individual and corporate financial planning, often offering significant tax advantages.