Life insurance has traditionally enjoyed substantial tax advantages in comparison to other financial products. In a nutshell, the cash value in a permanent policy grows on a tax-deferred basis and the death benefit is received income tax free. There have been many discussions in Congress over the years about repealing those advantages but, it seems that nobody has the stomach for taking money away from widow or orphans.
To fully appreciate the favorable life insurance tax treatment available today, consider some of the differences in how other financial products are taxed. For example, interest paid on savings accounts and stock dividends are subject to income taxation in the year in which the interest is paid and the dividends received. On the other hand, life insurance policy cash-values grow tax-deferred, and policy withdrawals and dividends (from participating policies) are generally received income-tax free up to an amount equal to the premiums paid (cash value and dividends received in excess of total premiums are generally taxable as ordinary income in the year received).
Death benefits are generally received completely free of income taxation. Even if a policy owner paid a premium of only $100 and his or her beneficiary received a death benefit of $100,000, no part of the death benefit would normally be taxable to the beneficiary as income. The significant disparity in the tax treatment given to life insurance compared to other financial products is due, in part, to the reluctance of the federal government to impose income taxes on a product designed to provide a financial life preserver to widows and orphans.
No matter how many times Congress looks at this, it seems they haven’t had the stomach to make any changes to the tax advantages of life insurance. Here’s hoping our current and future Congress don’t have a change of heart (or stomach).