Contributions (premiums) are not tax-deductible, but there is no maximum contribution to an annuity.
Tax Treatment of Cash Accumulation:
All growth in an annuity is tax-deferred until withdrawn.
Tax Consequences of a Withdrawal:
Any withdrawal from an annuity will be considered first a return of interest and represent taxable income. Only after all interest earnings are paid will withdrawals be considered a tax-free return of principal.
Withdrawals made before age 59½ will also be subject to a 10% IRS penalty. The only way to avoid this penalty is to annuitize.
Tax Consequences of Annuity Payments:
Taxation of annuity payments differs from withdrawals during the accumulation stage. The 10% penalty does not apply to an annuity contract that has been annuitized, regardless of the annuitant’s age. When an annuitant receives an annuity payment, the tax liability is in direct proportion to the percentage of the payment attributable to growth. The exclusion ratio is the amount of an annuity payment that is not subject to income tax when received, since it is considered to be the return of the original principal.
Tax Treatment of Life Insurance
Tax Treatment of Premiums:
Premiums paid for any individual life insurance policy are a personal expense and are not tax-deductible.
Premiums paid to fund group life insurance plans are tax-deductible by the employer, and generally, employees covered under a group health plan are not taxed on benefits received from group insurance. There is one exception:
Employer-paid premiums for group life insurance coverage in excess of $50,000 are considered taxable income to the employee.
Tax Treatment of Cash Value Accumulation:
The growth of a life insurance policy’s cash value accumulates on a tax deferred basis.
Tax Treatment of Policy Dividends:
In a participating policy, dividends paid to the policy owner are considered by the IRS to be a return of excess premium and are not taxable. In a non-participating policy, dividends are paid to stockholders and are taxable.
Tax Treatment of Death Benefits:
The IRS generally excludes life insurance policy proceeds from the beneficiary’s gross income. This is perhaps the most significant tax advantage of life insurance. It allows a person to provide for the economic security of a spouse or business associate without concern of creating an income tax liability for the beneficiary.
Tax Consequences of a Policy Surrender/Withdrawal:
Withdrawal of life insurance cash value is not taxable as long as the cash value does not exceed the sum of all premiums paid (cost basis). If cash value does exceed cost basis, any withdrawal from a life insurance policy will be considered first a return of interest and represent taxable income. Only after all interest earnings are paid will withdrawals be considered a tax-free return of principal.
Tax Treatment of Policy Loans:
Policy loans are an important feature of any whole life policy. When a policy loan is made by the insurer, it is done so with interest, but it is not a taxable event.
Lesson Summary
Life insurance products and annuities have specific tax consequences that individuals should be aware of:
Annuities Premiums: Contributions are not tax deductible, and there is no maximum contribution limit.
Annuities Cash Accumulation: Growth in an annuity is tax-deferred until withdrawal.
Annuities Withdrawal:
Withdrawals are considered taxable income, starting with interest earnings.
Withdrawals before age 59½ may incur a 10% IRS penalty unless annuitized.
Annuity Payments:
Payments are taxed proportionally to the growth percentage.
The 10% penalty doesn’t apply to annuitized contracts.
Life Insurance Premiums:
Individual policy premiums are not tax-deductible.
Group life insurance premiums generally are tax-deductible for the employer, but excess amounts may be taxable for employees.
Life Insurance Policy Dividends: Dividends in participating policies are considered return of excess premium and are not taxable.
Life Insurance Death Benefits: Usually excluded from the beneficiary’s gross income, making it a significant tax advantage.
Life Insurance Policy Surrender/Withdrawal: Cash value withdrawals are tax-free up to the cost basis, with interest taxed first.
Life Insurance Policy Loans: Policy loans are not taxable events, though interest may apply.
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