If you receive a death benefit, you can usually access the money from your policy by either withdrawing it or by surrendering it and ending it. One of the main reasons to purchase life insurance is simply to have easy access to the cash that builds up in the policy over time. If you do not pay taxes on the death benefit, you may end up paying higher taxes when the benefit is received by the beneficiary or estate. So be aware that the death benefit is not taxable, but paying taxes when the benefit is received is.
Some life insurance companies offer what they call universal default. This means that the benefits and premiums remain constant throughout the life of the policy, regardless of how the beneficiary wishes to make use of them. They do, however, have to provide notice of their choice of treatment for the cash payments. If the beneficiary does not wish to make use of the premiums, then the death benefit is taxable. And if the beneficiary does make a claim on the policy, then these payments are taxable.
The major reason to purchase insurance on a tax-free basis is the absence of capital gains and dividends. These taxes are only incurred once a profit has been made. The insurance company pays both the regular income taxes and capital gains taxes. Once the profit is made, then the dividends are paid, too. Life insurance companies are very keen on providing this option.
Another reason to purchase a tax bill is to ensure that your beneficiaries will not face a future taxation on any of their distributions from the insurance company. Any distribution is considered a taxable distribution. So, if you were to provide funds to your children or grandchildren in order to pay off a mortgage, the payment would be considered taxable. Your life policy's withdrawal money could be held in escrow and therefore, will not be taxable. A cash value insurance policy's withdrawal money is considered taxable income by the federal government. However, if it is held in trust, any money you withdraw will not be taxable until you take it out through an appropriate distribution method.
A third reason to purchase a tax bill is in order to increase the amount of cash value that can be accessed by the insured. Any money that is paid out to the beneficiary is considered taxable income by the Internal Revenue Service. When the death benefit is increased, the insured is able to access more cash. This increases the beneficiary's ability to pay off bills or consolidate debts.
How is a cash value or non-taxable policy different than a variable universal life policy? Non-taxable policies allow the insured to borrow against the cash value. When the insured borrows this cash, the value never decreases. The insured is also protected in the event of death. Unlike a variable universal life policy, however, the death benefit does decrease with each monthly payment made until it reaches zero.
As stated before, some policies provide the insured with a death benefit in order to help make payments as soon as possible. Other plans do not offer this benefit. When this happens, the value of the policy will decrease over time until it reaches zero. In such cases, the payout will be made to the named beneficiary or the account with the highest beneficiary rating.