Employee Life Insurance: Tax Implications When Paid By Employer

Life insurance is a financial product that pays out a lump sum in the event of the policyholder's death, providing financial support to their beneficiaries. When an employer provides life insurance as part of an employee's compensation package, the Internal Revenue Service (IRS) considers it income, which means the employee is subject to taxes. However, these taxes only apply when the employer pays for more than $50,000 in life insurance coverage. The premium cost for the first $50,000 in coverage is exempt from taxation. If the coverage exceeds $50,000, the employer-paid cost above this amount is included in the employee's taxable income, even though they do not actually receive it. This is often referred to as phantom income. The cost of group term life insurance is determined by a table prepared by the IRS, and this amount is used to calculate the taxable income, regardless of the employer's actual cost. This can result in older employees being taxed a higher amount than they would pay for similar coverage under an individual term policy.

The first $50,000 of employer-paid life insurance is tax-free

If your employer provides you with life insurance, you may consider it a desirable benefit. However, if the coverage is more than $50,000, there may be some unwelcome tax implications.

The first $50,000 of group term life insurance coverage provided by your employer is excluded from taxable income. This means that it doesn't add anything to your income tax bill. This exclusion applies whether the policy is carried directly or indirectly by your employer. A policy is considered carried directly or indirectly by the employer if they pay any cost of the life insurance, or if they arrange premium payments and the premiums paid by at least one employee subsidise those paid by another (the "straddle" rule).

However, if your employer-provided life insurance coverage is more than $50,000, the cost of coverage above this amount is considered taxable income, and you will be taxed on it, even though you haven't actually received it. This is known as "phantom income". The cost of coverage must be determined using a table prepared by the IRS, and this amount is included in the taxable wages reported on your Form W-2. As a result, older employees or those with higher compensation may find themselves in a higher tax bracket.

If you feel that the tax cost of your employer-provided life insurance is too high, you could look into whether your employer has a "carve-out" plan or is willing to create one. For example, an employer could provide $50,000 of group term insurance (which has no tax cost) and then provide an individual policy for the remaining coverage. Alternatively, an employer could give an employee the amount they would have spent on excess coverage as a cash bonus to put towards an individual policy.

Taxable income above $50,000

When an employee's taxable income exceeds $50,000, the taxation of their life insurance benefit provided by their employer becomes a bit more intricate. At this income level, the employee may be subject to higher tax brackets, and the tax treatment of their life insurance benefit can vary depending on several factors.

Firstly, it's important to understand that life insurance benefits are generally considered taxable income if they meet certain criteria. This includes group term life insurance policies provided by employers, where the benefit amount exceeds $50,000. If the employee pays the entire premium themselves, then the benefits are typically tax-free. However, when the employer pays the premium, things get a bit more complicated.

In the case of employer-paid premiums for life insurance benefits over $50,000, the employee is usually taxed on the value of the insurance protection provided. This is often referred to as the 'economic benefit' and is calculated using tables provided by the IRS. These tables take into account the employee's age and the prevailing interest rates to determine the taxable amount. The older the employee, the higher the taxable value, as the cost of insurance increases with age.

To illustrate with an example, let's consider an employee aged 45 with an employer-provided group term life insurance benefit of $100,000. If the employer pays the entire premium, the employee would be taxed on the economic benefit, which could be around $2,000 per year, depending on current interest rates. This amount would be added to their taxable income, pushing them into a higher tax bracket and resulting in a higher tax liability.

Calculating imputed income on insurance coverage

When an employer provides life insurance as part of an overall compensation package, the IRS considers it income, which means the employee is subject to taxes. However, these taxes only apply when the employer pays for more than $50,000 in life insurance coverage. The premium cost for the first $50,000 in coverage is exempt from taxation.

If your employer provides life insurance, you will likely find it to be a desirable fringe benefit. However, if group term life insurance is part of your benefits package, and the coverage is higher than $50,000, there may be undesirable income tax implications. The first $50,000 of group term life insurance coverage that your employer provides is excluded from taxable income and doesn't add anything to your income tax bill. But the employer-paid cost of group term coverage in excess of $50,000 is taxable income for the employee.

To calculate the reportable imputed income amount, you will need:

• The total amount of insurance coverage for each month
• The employee's age at the end of the calendar year
• The amount the employee pays per month for insurance after taxes
• The number of months for which coverage has been in effect

• Subtract $50,000 from the total amount of insurance coverage (the total benefit amount).
• Divide that number by 1000.
• Multiply the total by the Table I amount, based on the employee's age.
• Multiply the total from Step 3 by the number of months the employee was covered (for which this information is valid).
• Subtract the amount the employee has paid for coverage after tax.

If there is a change in the total benefit amount during the year, you will need to repeat steps 1-4 as many times as necessary and add the totals together before subtracting the amount the employee has paid (Step 5).

It is important to note that the cost of group term insurance must be determined under a table prepared by the IRS, even if the employer's actual cost is less than the cost figured under the table. This means that the amount of taxable phantom income attributed to an older employee is often higher than the premium the employee would pay for comparable coverage under an individual term policy.

Tax on interest from whole life insurance policies

The interest generated from whole life insurance policies is not taxed until the policy is cashed out. This is known as "tax-deferred", and it allows your money to grow faster as it is not reduced by taxes each year. The interest you make on your cash value is applied to a higher amount.

The cash value of your whole life insurance policy will not be taxed while it is growing. Interest and dividend payments from the insurance company can build up your cash value. In general, the "interest build-up" portion of the annual increase in the policy's cash value is not taxed annually by the IRS. Dividends are also generally not taxable, but this depends on which stage the cash value has reached, and you should consult a financial professional for advice.

If you decide to borrow against your cash value, this type of loan is not treated as taxable income. However, it will have interest charged by the insurance company until you pay it back, and each company has its own rates. You can also choose not to pay the loan back, but this will affect the amount of your life insurance payout to your beneficiaries.

When you cash out your whole life insurance policy, the amount you are taxed on is the difference between the cash value you receive and the total you paid in premiums during the time the policy was in force. For example, if you pay $100 per month for 20 years ($24,000) and then cash out the policy and receive $30,000, the amount subject to taxes is $6,000.

Taxation of Employer-Provided Life Insurance

When an employer provides life insurance as part of an overall compensation package, the IRS considers it income, which means the employee is subject to taxes. However, these taxes only apply when the employer pays for more than $50,000 in life insurance coverage. The premium cost for the first $50,000 in coverage is exempt from taxation.

Tax on life insurance proceeds

Life insurance proceeds are typically not taxable as income, but there are some situations in which taxes may be incurred. Here are some key points to consider regarding tax on life insurance proceeds:

Taxation for Beneficiaries

If you are the beneficiary of a life insurance policy, the death benefit is generally not considered taxable income by the IRS. However, if the policyholder delays the benefit payout, resulting in interest accumulation, you may be required to pay taxes on the accrued interest. Additionally, if you receive the benefit as a series of installments, the insurer may pay interest on the outstanding death benefit, which would be taxable as income.

Estate and Inheritance Taxes

Life insurance proceeds can be included in the value of your estate for tax purposes. If the total value exceeds federal and state exemptions, your beneficiaries may be subject to estate and inheritance taxes. Federal estate taxes apply when the value exceeds $12.06 million per individual, with a tax rate of up to 40%. State estate and inheritance taxes vary, with exemptions ranging from $1 million to $7 million and tax rates up to 20%.

Taxation on Interest and Dividends

Whole life insurance policies that accumulate cash value over time are treated differently for tax purposes. Interest generated from these policies is generally not taxed until the policy is cashed out or surrendered. If you receive dividends from a mutual insurance company, they are typically not taxed as income unless they exceed the total premium payments for the policy.

Taxation on Policy Transfers and Settlements

If you transfer ownership of your life insurance policy to another party before your death, the proceeds received by the beneficiary may be considered taxable income. Additionally, if you decide to cancel or surrender your policy, you may be subject to income and capital gains taxes on the cash value. Similarly, if you sell your policy through a life insurance settlement, a portion of the settlement may be taxed as income and capital gains.

Taxation on Group Term Life Insurance

If your employer provides group term life insurance as part of your benefits package, the first $50,000 of coverage is generally excluded from taxable income. However, if the coverage exceeds $50,000, the additional amount is considered taxable income, even if your employer pays the premiums. This is known as "phantom income" and is based on IRS tables.

Frequently asked questions