Texas General Lines — Life, Accident, Health and HMOLife InsuranceMedium
A life insurance agent is explaining the taxation of life insurance policy proceeds. Which statement regarding the taxation of death benefits and cash value withdrawals is generally accurate?
- ACash value withdrawals are generally tax-free up to the amount of premiums paid (cost basis).
- BInterest earned on the cash value is always taxable annually, even if not withdrawn.
- CPolicy loans are considered taxable income as soon as they are taken from the policy.
- DDeath benefits are typically taxable income to the beneficiary if they exceed the premiums paid.
Show answer & explanationAnswer & explanation
Correct answer: A. Cash value withdrawals are generally tax-free up to the amount of premiums paid (cost basis).
Death benefits are generally received income tax-free by the beneficiary. Cash value withdrawals are taxed on a 'first-in, first-out' (FIFO) basis, meaning the portion up to the premiums paid (cost basis) is considered a return of principal and is tax-free. Only amounts exceeding the cost basis are taxable.
Why the other options are wrong
- B. Interest earned on cash value grows tax-deferred, meaning it is not taxed annually unless withdrawn or the policy is surrendered for more than the cost basis.
- C. Policy loans are not considered taxable income when taken; they are a debt against the policy. They only become taxable if the policy lapses with an outstanding loan.
- D. Death benefits are generally income tax-free to the beneficiary, regardless of the amount.
Taxation of Life Insurance
The rules governing how death benefits, cash value growth, withdrawals, and loans from life insurance policies are treated for income tax purposes.
- Death benefits are generally income tax-free to beneficiaries.
- Cash value grows tax-deferred.
- Cash value withdrawals are tax-free up to the cost basis (premiums paid).
- Policy loans are generally tax-free, unless the policy lapses with an outstanding loan.
Memory trick: Death is Free, Cash is FIFO, Loans are Loans