In the United States, everyone knows that buying IUL insurance can be tax-free!
However, some of our friends who have just immigrated to the United States are not very clear about what taxes are exempted and why they are exempted.
Today, let’s talk about what taxes can be exempted from IUL policies in the United States!
Life Insurance Death Benefits
A death benefit from life insurance is a benefit from the estate, not subject to personal income tax, and subject to estate tax.
So why doesn’t life insurance count as income?
An example:
Suppose you own a house and have homeowners insurance.
If you are unfortunate enough to have your house destroyed by fire one day and the insurance company pays you the premium, should this premium be counted as your income? Of course not! Because you don’t have a house anymore, the insurance money is the money that compensates for the loss of the house.
The same applies to life insurance. Assuming that the insured is the main source of income for the family, if something happens to him, the death benefit is actually a replacement for him to continue to contribute to the family financially.
This is the logic behind the fact that the death benefit of a life insurance policy is not counted as income.
So how do you pay estate tax on a death benefit from a life insurance policy?
There are two scenarios:
1, Life insurance purchased by foreigners: Regardless of the status/nationality of the beneficiaries, no estate tax is paid on the death benefit as long as the policyholder is a non-U.S. person. Foreigners who purchase real estate in the U.S. are subject to U.S. estate tax in the event of an accidental death, and the exemption is not $11.4 million, but $60,000 instead.
2, life insurance purchased by U.S. persons: the amount of death benefits received by the beneficiary plus all other inheritance, in the estate tax exemption within the exemption amount of the tax-free, exceeding the part of the estate tax is required to pay the estate tax, this exemption amount is often changing, in 2019 for the 11.4 million U.S. dollars. The excess is taxed at an excessively progressive rate, such as 40% of the tax rate on the excess of $1 million.
Cash appreciation in life insurance accounts
Cash value appreciation in a life insurance account is exempt from personal income tax, but certain conditions must be met.
Life insurance premiums are subject to individual income tax before they are deposited. The reason that the cash value appreciation of the premiums after they are deposited into the insurance policy is tax-free is because most people use their money in the form of principal withdrawals or loans. Where the principal is taxed money, the loan is not income, so neither is subject to income tax.
When some brokers sell life insurance, some key details are not made clear, such as this point, intentionally or unintentionally vague as “withdrawals from life insurance policies are tax-free”.
You can only withdraw money from a policy that has a savings and investment function. The amount of money that can be withdrawn is determined by the cash value of the policy.
Why emphasize policy loans?
Because the death benefit of a life insurance policy is originally left to the beneficiary after the person passes away, but now we can use it for ourselves, in fact, we are actually “borrowing” the death benefit from the beneficiary of our policy in advance to use it. The collateral for the “loan” is the cash value of the policy. This is why the amount of money that can be “borrowed” from the policy must be within the cash value of the policy.
Since it’s a loan, naturally there will be interest. But on the one hand, the money is your own, and on the other hand, since the insurance company wants to make “getting money while you are alive” as a selling point, the interest rate charged is extremely low, and in some cases, it is even zero percent.
Prior to 1980, the money put into life insurance was tax-free and no conditions were set.
Later, more and more people used insurance to avoid taxes, so exaggerated that some people actually put millions of cash into the policy at one time, but the insured amount is only a few tens of thousands of dollars, and the insured used the policy to avoid a large amount of personal income tax.
In order to cope with this situation, the IRS issued several bills after 1984, stipulating what kind of life insurance policy money is tax-free, these regulations are still in effect.
For a policy to be tax-free, two conditions need to be met:
1, the amount of annual premiums paid for the policy cannot exceed the maximum amount set by the IRS, otherwise it will need to be taken out in the future and taxed on the gross proceeds.
The IRS has Life Insurance Definitional Testing and MEC (modified endowment contract) testing for every life insurance policy, and those that pass the test enjoy tax exemption.
What happens if a policy fails the test and becomes a MEC policy?
a. Policy withdrawals are taxed by the IRS on the basis of the total appreciation in value beyond the principal amount of the policy, and the tax is calculated on the basis of the individual income tax.
b. Money withdrawn from the policy before age 59½ is subject to a 10% penalty to the IRS.
c.Once a policy is recognized as a MEC, it is a MEC for life.
d.At the time of premium payment, the policyholder has two months to adjust the payment if he or she finds that the payment amount exceeds the maximum amount that can be saved for the year. Nowadays, every policy will do this test for the customer at the proposal stage, and the broker will clearly inform the customer of the maximum amount that can be saved in a year, the recommended number of years to save, how much to save per year, what will happen if it exceeds, etc.
2, The policy cannot be terminated prior to death at the time of the drawdown.
If the policy is terminated before death, the IRS will consider the policy not as insurance, but as an investment.
The investment is subject to capital gains tax, which is levied on the total amount of money withdrawn by the client minus the total amount of principal invested. The tax rate is based on the long-term capital gains tax rate and is related to the tax bracket in which the insurance policy is placed in the year of termination.
Life insurance termination (Lapse), we often see this word in a plan.
For example, if you save $10,000 per year for 20 years and save a total of $200,000, and you haven’t had a chance to withdraw the money yet, and then in the 25th year, the policy Lapses, then you don’t have to pay income tax. But if you withdraw money from the policy, say for 10 years at $50,000 a year for a total of $500,000, and the policy Lapses in the 30th year, then $500 - $200 = $300,000 is subject to capital gains tax.
Premium tax paid by insurance companies to their customers
When premiums are paid, the insurance company pays a premium tax on behalf of the customer. All life insurance companies charge a fee, usually 6-8%, for each premium received, and this amount includes the premium tax charged by the states, which is about 3%.
This portion of the tax is mandatory and is paid on all life policies in the U.S. Tax rates vary slightly from state to state. Each company charges a slightly different rate and collects it in a slightly different way. Now there is some understanding of life insurance tax exemption in the United States Boo!
