Life Insurance And Taxes: What's The Write-Off Story?

Life insurance premiums are generally not tax-deductible, but there are exceptions. For instance, if you run a business, you may be able to deduct the cost of premiums as a business expense, depending on the type of policy and whether the company is the beneficiary. Additionally, if the beneficiary of your policy is a charitable organisation, the premiums could qualify for a charitable deduction. While life insurance premiums may not be tax-deductible, the death benefit is usually tax-free for beneficiaries, and policies with cash value offer potential tax advantages.

Group term life insurance for employees

Group term life insurance is a type of temporary life insurance that covers multiple people under a single contract. It is commonly offered by employers as part of their benefits package, with some providing basic coverage at no cost to employees. This type of insurance is relatively inexpensive compared to individual life insurance policies and is often supplemented by additional coverage that employees can purchase for themselves and their families.

According to the Internal Revenue Service (IRS) Code Section 79, employers can provide their employees with up to $50,000 of group term life insurance coverage tax-free. This means that the first $50,000 of coverage is excluded from taxation. However, if the employer-provided coverage exceeds this amount, the additional coverage becomes a taxable fringe benefit. The cost of coverage above $50,000 must be included in the employee's income and is subject to social security and Medicare taxes. This taxable amount is calculated using the IRS Premium Table, which determines the cost per thousand dollars of coverage based on the employee's age.

It is important to note that group term life insurance is linked to ongoing employment. Therefore, if an individual leaves their job, their coverage under the group policy typically ends. However, some insurance companies offer the option to convert group term coverage into an individual permanent life insurance policy, although this may result in higher premiums.

While group term life insurance through an employer can be a valuable benefit, it is important to consider its limitations. The coverage amount may not be sufficient to meet the financial needs of an individual's loved ones, and it is not portable if one changes jobs or retires. As a result, individuals may want to consider purchasing additional individual coverage to ensure adequate protection for their families.

Giving life insurance to charity

There are a few ways to donate your life insurance policy to a charity. It's important to note the tax consequences, which vary depending on the method used. Here are some options:

Naming the Charity as the Beneficiary of a Policy

You can name a charity as the beneficiary of your life insurance policy, just like you would name a person. You can divide the death benefit among your loved ones and the charity as you wish. If you already have a policy, changing the beneficiary is a simple process. However, this option does not offer income tax advantages, and the policy could be counted in the owner's estate for estate tax purposes.

Transfer Ownership of a Policy to a Charity

Instead of naming a charity as the beneficiary, you can transfer ownership of an existing policy to them. This gives the charity immediate control, and they can name themselves as the beneficiary of a tax-free payout when you pass away. If it's a permanent life insurance policy with cash value, the charity won't have to wait and can surrender the policy for cash. Transferring ownership allows you to take an immediate charitable contribution tax deduction, and if you continue paying premiums, you can deduct those as well. However, this decision is irrevocable, and the charity now has control of the contract.

Gift Dividends from a Life Insurance Policy

If you want a charitable contribution tax deduction but don't want to transfer ownership, you can gift the dividends from your permanent life insurance policy to a charity. You can take a tax deduction for donating dividends, and you maintain ownership of your policy. However, gifting dividends will not provide as much benefit to the charity as the other options.

Alimony agreements

Alimony, or spousal support, is a type of payment that helps a former spouse or partner maintain a similar standard of living to which they were accustomed before a divorce. It is separate from child support, property settlements, or a former spouse's share of community property.

Alimony payments are no longer tax-deductible for payers, nor are they included as income for recipients, unless they were included in a divorce decree finalised before 2019. This is due to the Tax Cuts and Jobs Act of 2017, which changed the taxation of alimony on federal tax returns.

For alimony agreements made prior to 2019, alimony payments are typically deductible by the payer and must be reported as taxable income by the recipient. However, alimony payments are only deductible if they meet all of the following Internal Revenue Service (IRS) criteria:

• You don't file a joint tax return with your former spouse.
• You make payments in cash, by check, or by money order.
• You make payments to or for a spouse or former spouse under an applicable divorce or legal separation agreement.
• Legally separated spouses cannot be part of the same household when making payments.
• Liability for the payment doesn't extend beyond the death of the spouse who receives payments.
• The payment is not child support or a property settlement.

If your divorce papers are modified to explicitly state that the repeal of the deduction for alimony payments applies, payments under your divorce agreement will be taxed according to the new rules.

Death benefit taxation

In general, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income. This means it isn't subject to income tax. However, there are some instances where a death benefit can be taxed.

For example, if the payout is structured as multiple payments, these can be taxable. This includes annuities, which are paid regularly over the life of the beneficiary and can be subject to taxes.

Another instance where a death benefit can be taxed is when the policyholder has withdrawn money or taken out a loan against the policy. If the amount withdrawn or loaned is more than the total amount of premiums paid, the excess may be taxable.

If you surrender your policy, any funds over your policy's cash basis will be taxed as regular income. Also, according to the Internal Revenue Service (IRS), if life insurance proceeds are included as part of the deceased's estate and together exceed the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. As of 2023, this threshold was $12.92 million.

Death benefits for business-related beneficiaries are often tax-free, but there are situations in which the death benefit for corporate-owned life insurance can be taxable. However, employers offering group term life coverage to employees can deduct premiums that they pay on the first $50,000 of benefits per employee, and these amounts are not counted as income for the employees.

If the policyholder names their estate as a beneficiary, taxes may apply depending on the estate's value. Additionally, if the insured and the policy owner are different individuals, there may be taxes involved.

To avoid taxation, you can transfer ownership of your policy to another person or entity. Alternatively, setting up an irrevocable life insurance trust (ILIT) will own the life insurance policy, meaning the proceeds will not be included in your estate.

Business-related premiums

Life insurance premiums are generally not tax-deductible, but there are exceptions for businesses that provide coverage to their employees. If you are a business owner, you may be able to deduct the cost of premiums paid on behalf of your employees or corporate officers, as long as the company is not a direct or indirect beneficiary of the policy. This is known as a business-related premium.

The IRS allows an exclusion of the first $50,000 of group term life coverage offered by some small business owners. The total benefit of the policy cannot exceed $50,000; above that amount, the cost of coverage must be included in income and is subject to Social Security and Medicare taxes. In these cases, the small business can deduct the premiums paid on behalf of employees from their taxes.

For employees who earn more than $50,000 and are offered life insurance for the amount of their annual salary, they will have to pay income taxes on the premium coverage above $50,000. The premium for the first $50,000 is covered.

It is important to note that you cannot deduct premiums for any life insurance policy where you or your company are the beneficiary. Additionally, the rules regarding tax deductions for life insurance premiums can be complicated, and it is always recommended to consult a tax professional for personalized advice.

Frequently asked questions