Life Insurance And Taxes: What's The Deal?

Life insurance is a financial instrument designed to minimise the financial impact on a family when the breadwinner passes away. When you buy a life insurance policy, you enter into a contract with the insurance company, wherein you agree to pay the premium and the insurer agrees to pay a lump sum to the appointed nominee as a death benefit. The insurance company will pay policy benefits, including the sum assured and other accrued benefits to the appointed beneficiary. The proceeds received from the insurance will help them take care of their future expenses as well as meet the liabilities and debts.

One of the striking features of life insurance policies is the tax benefits it carries. The life insurance tax deduction is guaranteed by the Indian Income Tax Act, 1969. Section 80C of the IT Act assures tax deduction on the money paid as premium towards your life insurance policy. The maximum limit on tax deduction in a financial year is Rs. 1.5 lakhs. If the premium value is more than 10% of the sum assured, then the maximum tax benefit you get is 10% of the sum assured.

Apart from the tax benefit available on the premium payment, the death benefits paid to the nominee are subject to tax deduction under Section 10 (10D). When the nominee receives the sum assured as the death benefit, it is not treated as income and therefore it is tax-free. There is no limit on the maximum amount for tax exemption.

Tax benefits on life insurance premiums

Life insurance premiums are not usually tax-deductible. However, there are certain circumstances where the IRS will treat life insurance premiums differently, and you will face certain tax consequences. These cases most often arise when a business owns or pays for the life insurance policy. Here are some of the tax benefits and considerations for life insurance premiums:

• Business-paid premiums: If you're a business owner, you can deduct business-paid premiums for life insurance policies owned by company executives and employees. The executive or employee then reports the premium as income.
• Permanent life insurance cash value: Permanent life insurance policies feature a cash accumulation component that grows over time, and taxes on this growth are deferred. The cash value can be used as collateral for loans, to pay for college or a house, or even to cover premium payments. If you surrender your policy, the cash value is typically tax-free up to your "basis," or the total amount of premium payments made. Any amount above this basis is considered a gain and is taxed as ordinary income.
• Permanent life insurance dividends: Cash dividends received from a life insurance policy are generally tax-free and don't need to be reported as income, as long as they don't exceed the net premiums paid on the policy.
• Self-employed workers: Self-employed individuals can deduct health, dental, and long-term care premiums, as well as business-related insurance premiums, including vehicle insurance if they meet certain criteria.
• Disability insurance: While disability insurance premiums are not typically tax-deductible, there is an exception for self-employed taxpayers. The IRS allows them to deduct "overhead insurance" that covers business overhead expenses during periods of disability due to injury or sickness.
• Death benefits: Life insurance death benefits are generally tax-free for individual policy owners and their beneficiaries. However, if the benefit is paid out over time with interest, those interest payments will be taxable.
• Tax-free payouts: In certain cases, life insurance payouts may be completely tax-exempt. For policies issued after April 1, 2012, if the premium paid does not exceed 10% of the sum assured, any amount received upon the death of the insured or on the maturity or surrender of the policy is fully exempt from tax. This exemption also applies to bonuses received.
• Tax-deductible premiums: In India, premiums paid for life insurance policies are eligible for tax benefits under Section 80C of the Income Tax Act. The maximum deduction allowed is up to ₹1.5 lakh per financial year.

Tax exemption on death benefits

In most cases, death benefits are not taxed. In Canada, proceeds from a life insurance policy are not subject to taxes and are not treated as taxable income by the Canadian Revenue Agency (CRA). Similarly, in the US, death benefits are not counted as taxable gross income.

However, there are certain situations where taxes may be incurred. For instance, if the policyholder elects to delay the benefit payout and the money is held by the insurance company for a given period, the beneficiary may be taxed on the interest generated. Additionally, if the policyholder names their estate as the beneficiary, the death benefits may be taxed, and the person(s) inheriting the estate may have to pay estate taxes.

To avoid such taxes, it is recommended to appoint a named beneficiary on the policy. In the US, the first $10,000 of the death benefit is always tax-exempt, and the remaining amount is reported on the tax returns by the estate's beneficiaries. In India, for life insurance policies issued after April 1, 2012, if the premium paid does not exceed 10% of the sum assured, the amount received on the death of the insured is fully exempt from tax.

Tax on interest generated by delayed benefit payouts

Life insurance payouts are generally not taxable, but there are certain situations in which they are. One such situation is when the policyholder elects to delay the benefit payout, and the money is held by the life insurance company for a given period. In this case, the beneficiary may have to pay taxes on any interest generated during that period.

When Interest is Taxable

If the policyholder chooses to delay the benefit payout, and the insurance company holds the funds for a period of time, any interest generated during that period is typically subject to federal income tax. This is true regardless of whether the beneficiary receives the proceeds as a lump-sum distribution or in periodic payments.

Calculating Taxable Interest

The taxable amount of interest is calculated based on the proportion of the death benefit to the total payout. For example, if a $250,000 policy pays out $2,200 per month for 10 years, resulting in a total payout of $264,000, $250,000 divided by $264,000 equals 95%. Therefore, $110 of the $2,200 monthly payment is taxable interest.

Reporting Interest Income

When the beneficiary chooses to keep the payout on deposit with the insurance company, earning interest, the insurance company will typically send a Form 1099 each year to report the amount of interest earned. The beneficiary must report this interest as income on their tax return for the year in which it was earned, even if they choose to leave it on deposit with the company.

Interest on Late Payments

In addition to interest on delayed benefit payouts, interest may also be imposed by the tax authorities for late payment of taxes. Sections 234A, 234B, and 234C of the Income Tax Act outline penalties for delayed Income Tax Return (ITR) filing and late payment of advance taxes. Interest under these sections is typically calculated at a rate of 1% per month or part of a month on the outstanding tax amount.

To summarise, while life insurance payouts are generally not taxable, the beneficiary may be subject to taxes on any interest generated by delayed benefit payouts. It is important for beneficiaries to understand the tax implications of their choices and consult a tax professional for advice specific to their situation.

Inheritance and estate tax

In most cases, beneficiaries are not taxed on their life insurance payout. However, there are some exceptions. If the beneficiary is an estate rather than an individual, the person(s) inheriting the estate may have to pay estate taxes. This is because the payout is considered part of the estate's value, which could be subject to exceptionally high estate taxes.

In the US, estates over $13.61 million owe estate tax. Federal taxes won't be due on many estates, however. The basic exclusion amount for an estate for a decedent that passed away in 2022 is $12.06 million, and the exclusion amount for 2023 is $12.92 million. The top-tier tax rate is capped at 40%.

In the UK, the threshold for estate tax is £325,000. If the estate is valued above this amount, inheritance tax will be charged at 40% on the portion of the estate that exceeds the threshold.

In India, the tax treatment of life insurance in the event of death is governed by Section 10(10)D of the Income Tax Act, 1961. The amount of sum assured plus any bonus (i.e. the policy proceeds) paid on maturity or surrender of the policy, or on the death of the insured, is completely tax-free for the receiver, subject to certain conditions.

In Australia, life insurance payouts are generally not taxed. However, if the payout is made to a deceased person's estate, rather than directly to a beneficiary, it may be subject to tax.

In Canada, life insurance death benefits are generally not taxable. However, if the beneficiary is the policyholder's legal representative (i.e. the estate), the benefit may be taxable.

In South Africa, life insurance payouts are generally not taxed, regardless of whether the beneficiary is an individual or the insured's estate.

Tax on maturity proceeds

In general, life insurance payouts are not taxable, and beneficiaries do not have to pay taxes on the money they receive. However, there are certain situations in which the maturity proceeds from a life insurance policy may be taxable. Let's take a closer look at the tax implications of maturity proceeds under different scenarios.

Tax Exemption on Maturity Proceeds:

• For policies issued after 1st April 2012: If the premium paid does not exceed 10% of the sum assured, any amount received upon the maturity or surrender of the policy is fully exempt from tax. This includes any bonuses received.
• For policies issued before 1st April 2012: The tax-exemption threshold is higher. If the premium paid does not exceed 20% of the sum assured, then the maturity proceeds and any bonuses received are fully exempt from income tax.
• For policies covering individuals with disabilities or specific diseases: As per Sections 80U and 80DDB, if the policy was issued after 1st April 2013 and the premium does not exceed 15% of the sum assured, the maturity proceeds are tax-free.

Taxable Situations on Maturity Proceeds:

• For policies issued between 1st April 2003 and 31st March 2012: If the premium paid exceeds 20% of the sum assured, the maturity proceeds will be taxable.
• For policies issued after 1st April 2012: If the premium exceeds 10% of the sum assured, the maturity proceeds will be taxable.
• For policies issued after 1st April 2013 covering individuals with disabilities or specific diseases: If the premium exceeds 15% of the sum assured, the maturity proceeds will be taxable.
• Single-premium life insurance policies: If the premium paid exceeds 10% of the sum assured, the maturity proceeds may be taxable.

It's important to note that the above conditions and thresholds may vary depending on the country and specific tax laws. Additionally, tax laws and regulations are subject to change, so it is always advisable to consult a tax professional or financial advisor for the most accurate and up-to-date information.

Frequently asked questions