You know that life insurance offers protection for your loved ones, providing them with a cash payout upon your death. But did you know that life insurance policies also come with several valuable tax benefits?
It's true: Both term and whole life insurance policies provide tax benefits that could reduce the amount of money you or your survivors have to pay to Uncle Sam.
Here are some of the biggest tax advantages that you'll receive when taking out life insurance:
1. Payouts bring life insurance tax benefit when you die
The money that your beneficiaries receive after you die is not subject to taxes. This is important: If your policy pays your children $700,000 on your death, these beneficiaries will receive the entire sum. They won't have to share any of these dollars with the government.
There is an exception, though, for the very wealthy. Payouts from life insurance policies can be considered part of your estate after you die. If your estate is large enough so that it can be taxed, your beneficiaries will have to pay some taxes on their payout from your life insurance policy. However, this is rare: The estate tax only applies to estates worth more than $5.45 million in 2016. If your estate is under that figure? Your beneficiaries won't have to worry about taxes on their life insurance payout.
2. Gains in cash value for permanent life insurance policies
There are two types of life insurance policies, term and permanent. Term life insurance is the simplest type: It lasts a certain number of years — often 20 — and provides a specific payout. Once that term ends, you can either let the policy lapse if you no longer need it or you can renew it.
The other main form of life insurance is permanent. This insurance is designed to last for your entire life. Because of this, it is more expensive. Permanent life insurance also comes with an investment component, often referred to as the "cash value" portion. When you pay your premiums, some of the money goes into a savings account attached to your policy. Your insurance company then pays interest on that money so that it grows over time. When you die, your beneficiaries receive both the death benefit and the money in this savings account. You can also borrow against the cash-value portion of your policy if you need extra cash.
One of the benefits of this is that the gains in your cash value are not subject to taxes, as long as they remain in your life insurance account.
3. Payouts when you close your life insurance policy
You might decide that it's time to close your life insurance policy. Maybe your beneficiaries no longer need the financial boost from a life insurance payout. The good news? When you surrender your life insurance policy you'll receive a lump-sum payout. You won't owe taxes on that payout as long as the sum is equal to or less than what you've paid into the policy over time.
See also: Are you ever too old for life insurance? When to cancel your policy
There is a big exception here, though. The cash-value portion of your permanent life insurance policy might have grown enough so that the money you receive when you surrender your policy is higher than the amount you paid into it. You'll have to pay taxes on the portion of your payout that exceeds what you paid into your policy. That's because that growth in your cash value is considered income by the IRS.