Employee Life Insurance: Taxable Or Not?

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 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 is included in the taxable wages reported on the employee's Form W-2, even though the employee does not actually receive this money. This additional taxable income is often referred to as phantom income.

Employer-paid life insurance over $50,000 is taxable

If your employer provides life insurance, it is likely considered a fringe benefit. There are taxable and nontaxable fringe benefits. 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. This is because the IRS considers the first $50,000 of group-term life insurance coverage provided under a policy carried directly or indirectly by an employer as an exclusion.

However, employer-paid life insurance over $50,000 is taxable income. This is considered "phantom income" because it is included in the taxable wages reported on your Form W-2, even though you never actually receive it. 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. 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. This tax trap gets worse as an employee gets older and as their compensation increases.

If you believe the tax cost of employer-provided group-term life insurance is too high, you can establish if this is the case by checking if a specific dollar amount appears in Box 12 of your Form W-2 (with code "C"). This dollar amount represents your employer's cost of providing you with group-term life insurance coverage in excess of $50,000, less any amount you paid for the coverage. You are responsible for federal, state, and local taxes on the amount that appears in Box 12, as well as the associated Social Security and Medicare taxes. Keep in mind that the amount in Box 12 is already included in your total "Wages, tips, and other compensation" in Box 1 of the W-2, and it is the Box 1 amount that is reported on your tax return.

If you decide that the tax cost is too high for the benefit you are receiving, you can find out if your employer has a "carve-out" plan or is willing to create one. With a "carve-out" plan, the employer can continue to provide $50,000 of group-term insurance (as there is no tax cost for the first $50,000 of coverage) and then provide the employee with an individual policy for the balance of the coverage. Alternatively, the employer can give the employee the amount they would have spent for the excess coverage as a cash bonus that the employee can use to pay the premiums on an individual policy.

Phantom income and tax traps

Phantom income is a term used to refer to income that is considered taxable by the IRS but does not exist in a physical form that the taxpayer can spend. This can occur in situations where an employer provides benefits to an employee, such as life insurance, which the IRS considers as income.

When an employer provides life insurance as part of an employee's compensation package, the IRS treats it as income to the employee, making it subject to taxes. However, these taxes only apply when the employer-paid life insurance coverage exceeds $50,000. The premium cost for the first $50,000 in coverage is generally exempt from taxation. If an employer provides an employee with $50,000 in life insurance coverage, the employee doesn't have to pay taxes on this benefit as it falls within the threshold set by the IRS. On the other hand, if an employer pays for a $100,000 life insurance policy, the employee must pay taxes on the portion above $50,000. The taxable amount is based on IRS tables, which determine the additional taxable income attributed to the excess coverage.

In addition to the life insurance benefit itself, interest generated from whole life insurance policies is also considered taxable income. The interest accumulated in these policies is not taxed until the policy is cashed out. At that point, the policyholder is required to pay taxes on the difference between the cash value received and the total amount paid in premiums during the policy's duration.

Another tax trap to be aware of is the "lookback period" when filing for refunds. While the IRS has the authority to postpone filing deadlines in certain situations, such as disaster relief, these postponements can create a trap for taxpayers, preventing them from receiving a refund even if they file a timely and meritorious claim. This trap occurs because the "lookback period" can fall out of sync with refund claim filing deadlines. Therefore, it is crucial for taxpayers to be aware of both the filing due date and the date of their prior payments to avoid missing out on refunds.

Carve-out plans and tax savings

Carve-out plans are a type of life insurance benefit that employers can use to reward key employees beyond what is available through the company's group term life insurance policy. These plans are designed to overcome some of the limitations of group term life insurance, such as the requirement to provide coverage on a non-discriminatory basis, the high cost of coverage at retirement, and the loss of coverage upon termination.

In a carve-out plan, the employer provides selected employees with $50,000 in tax-free term insurance, as well as a permanent life policy that can accumulate cash value over time. This permanent life policy is often in the form of universal life insurance, which is portable and not subject to non-discrimination rules, allowing employers to offer it to certain employees of their choosing. By structuring the plan in this way, the employee will often pay less income tax on their employer-provided permanent coverage compared to the same amount of group term life insurance.

The employer also receives benefits from a carve-out plan. They can claim a current tax deduction for the premiums they pay for the group term life insurance and, in some cases, for the employee's individual insurance policy. Additionally, the employer can deduct the employer-paid portion of the individual policy premium as compensation. One of the most significant advantages for employers is the ability to retain key employees by offering a more attractive insurance and retirement package.

However, there are also limitations to consider. Depending on how the plan is designed, employers may not be able to deduct the premiums they pay for the permanent insurance. Furthermore, there is no guarantee that the carve-out plan will successfully retain valuable employees, especially if they are recruited by a company with a better carve-out plan.

Group term life insurance and the IRS

Group term life insurance is a benefit offered by some employers to their employees. The Internal Revenue Service (IRS) treats it differently from other types of financial products. The IRS imposes different tax rules on different plans, and sometimes the distinctions are arbitrary.

IRC section 79 provides an exclusion for the first $50,000 of group-term life insurance coverage provided under a policy carried directly or indirectly by an employer. There are no tax consequences if the total amount of such policies does not exceed $50,000. The imputed cost of coverage in excess of $50,000 must be included in income and is subject to Social Security and Medicare taxes.

A taxable fringe benefit arises if coverage exceeds $50,000 and the policy is considered carried directly or indirectly by the employer. A policy is considered carried directly or indirectly by the employer if the employer pays any cost of the life insurance, or if the employer arranges for the premium payments and the premiums paid by at least one employee subsidize those paid by at least one other employee (the "straddle" rule).

The determination of whether the premium charges straddle the costs is based on the IRS Premium Table rates, not the actual cost. The benefit is taxable even if the employees are paying the full cost they are charged. You must calculate the taxable portion of the premiums for coverage that exceeds $50,000.

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. It's included in the taxable wages reported on your Form W-2, even though you never actually receive it.

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. With these determinations, 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. This tax trap worsens as an employee gets older and as their compensation increases.

If you decide that the tax cost is too high for the benefit you're getting in return, find out whether your employer has a "carve-out" plan or is willing to create one. The employer can continue to provide $50,000 of group term insurance (since there's no tax cost for the first $50,000 of coverage). Then, the employer can provide the employee with an individual policy for the balance of the coverage. Alternatively, the employer can give the employee the amount the employer would have spent for the excess coverage as a cash bonus that the employee can use to pay the premiums on an individual policy.

FICA and taxable wages

The Federal Insurance Contributions Act (FICA) includes taxes for old-age, survivors, and disability insurance, also known as Social Security taxes, and hospital insurance taxes, also known as Medicare taxes. The Social Security tax rate is 6.2% for both the employer and the employee, or 12.4% total, while the Medicare tax rate is 1.45% for both the employer and the employee, or 2.9% total. These FICA taxes are applied to all taxable compensation, including salary, wages, tips, bonuses, commissions, and taxable fringe benefits.

For Social Security taxes, there is a wage base limit, above which the tax no longer applies. This base limit is adjusted annually to account for cost-of-living changes; for 2023, the wage base was $160,200, and for 2025, it is $176,100. There is no wage base limit for Medicare taxes; all covered wages are subject to this tax.

When it comes to employer-provided life insurance, the first $50,000 of group term life insurance coverage is excluded from taxable income. However, if the employer-provided coverage exceeds $50,000, the additional amount becomes taxable income for the employee. This is considered "phantom income" as it is included in the taxable wages on the employee's Form W-2, even though the employee does not actually receive it. The cost of this additional coverage is determined by a table prepared by the IRS, and it often results in higher taxes for older employees with higher compensation.

To calculate the FICA tax, the first step is to determine the compensation to which FICA is applied. This includes all taxable compensation, such as salary, wages, commissions, bonuses, and tips, as well as taxable fringe benefits. The next step is to assess whether the compensation exceeds the annual Social Security wage base. If it does not, the FICA tax rate applied is 7.65% (the sum of the Social Security and Medicare tax rates). If the compensation is above the wage base, the Social Security tax rate is applied to wages up to the base limit, and the Medicare tax rate is applied to all compensation.

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