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Life Insurance and Taxes

By Compuquotes Team on March 26th, 2008

There are several tax benefits associated with life insurance. There are some pitfalls associated with taxes too, which it's important to be aware of. The relationship between life insurance and taxes is very complex-to make sure you fully understand the possible consequences of the way you set up your life insurance policy it's always best to consult your insurance agent or another financial advisor. In the mean-time, here's an overview of some of the benefits and potential problems when it comes to taxation.

Paying Taxes on Life Insurance Pay-outs

The most well-known benefit associated with life insurance is probably that lump sum payments on life insurance claims are not taxable unless they are included as part of the deceased's estate, which is only the case if the deceased themselves owns the policy or if the deceased names themselves or their estate as a beneficiary. Life insurance policies are therefore an excellent way of transferring income to your family after your death. A good life insurance policy can help offset the losses caused by federal and state estate taxes (if they apply to you), and help ensure that your dependants remain financially stable.

For various reasons, some people may choose to receive life insurance money in regular installments rather than as a lump sum. If you choose to do this, part of each installment is taxable, because part of that money will include interest. To find out how much insurance money is tax-free per year, divide the total amount of money you will receive from the policy by the number of years you will receive it for. The remainder is interest, and must be declared as taxable income on your tax return for the year in which you receive it.

Mutual Insurance Policies

If you have a life insurance policy with a mutual insurance company, you can receive dividends from that company each year. Dividends are simply surplus profits that are distributed by the company to all insurance policy holders. The amount you receive each year varies according to the company's surplus that year and also depends on the type and value of the policy you own.

The important point is that these dividends are not taxable income-they only become taxable at the point that the amount you receive in dividends exceeds the amount you have paid in premiums (which is unlikely to happen to most people). However, should you choose to invest the money, the interest you earn is taxable and should be declared on your tax return in the year that the interest is credited to you.

Note that dividends gained in this way are different from dividends obtained from owning shares in an insurance company-dividends you receive from owning shares are always taxable regardless of the amount you receive.

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