Life Insurance And Tax: What's The Deal?

Life insurance is often seen as a reliable way to provide for loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs or securing their future. However, there are some situations where taxes could come into play, and it's important to know when that might happen.

Are life insurance proceeds taxable?

Life insurance proceeds are usually not taxable as income. However, there are certain situations where life insurance proceeds may be taxable.

Interest on Death Benefits

If a beneficiary chooses to delay the payout or take the payout in installments, interest may accrue. In that case, the interest paid to the beneficiary may be taxed.

Payout Goes Into a Taxable Estate

If a beneficiary is not named, or is already deceased, the life insurance death benefit goes into the estate of the insured person and can be taxable along with the rest of the estate.

The Life Insurance Policy Involves Three Different People

Life insurance death benefits can become a taxable gift in a situation where three people serve three different roles in connection with the life insurance policy: the policy owner, the insured, and the beneficiary. In this case, the IRS considers the life insurance payout a gift from the policy owner to the beneficiary, and the policy owner may have to pay gift tax if the payout exceeds federal gift tax exemption limits.

Surrendering the Policy

If you surrender a cash value life insurance policy, you can generally expect to get a surrender charge within the first 10 or 20 years of owning the policy, and over time the surrender charge phases out. You won't be taxed on the entire surrender value, but on the amount you received minus the policy basis, or the total premium payment you made on the policy.

Taking Out a Policy Loan

If you have a policy with cash value and take a life insurance policy loan against it, the loan isn't taxable—as long as the policy is in force. But if the policy terminates before you've paid the loan back, you could get a tax bill. The taxable amount is based on the amount of the loan that exceeds your policy basis.

Selling the Policy

There's a market for existing life insurance policies, especially cash value life insurance policies that insure people who are terminally ill or have short life expectancies. These transactions are called "viatical settlements," and the IRS doesn't treat any portion of what you receive for a viatical settlement as taxable. However, if you sell your policy and you're not terminally ill, the IRS does not see the proceeds as a payment of death benefit, and a portion of what you receive can be taxable.

Is the cash value of life insurance taxable?

The cash value of a life insurance policy refers to the money that builds up within the policy over time. This value can be accessed through a withdrawal, a loan, or by surrendering the policy and ending it. While the cash value in a life insurance policy is generally tax-free, there are certain situations where it may be subject to taxation.

One reason to buy a cash value life insurance policy is to have access to the money that accumulates within the policy. When you pay premiums, the payments generally go towards three places: cash value, the cost of insuring you, and policy fees and charges. The money within the cash value account grows tax-free, based on the interest or investment gains it earns, but once you withdraw the money, you may have to pay taxes on it.

If you surrender a cash value life insurance policy, you will receive the cash value minus any surrender charges. However, you will only be taxed on the amount you receive minus the policy basis or the total premium payments you have made on the policy. This taxable amount reflects the investment gains that you have taken out.

If you have a policy with cash value and take out a loan against it, the loan is not taxable as long as the policy is still in force. However, if the policy terminates before you have repaid the loan, you may be taxed on the amount of the loan that exceeds your policy basis.

In the case of a modified endowment contract (MEC), the tax rules are different, and it is best to consult a financial professional to understand the tax implications. With a MEC, withdrawals are treated on a last-in, first-out (LIFO) basis, meaning that all withdrawals are considered taxable income until they equal the interest earnings in the contract.

While the cash value of a life insurance policy is generally not taxable, it is important to understand the specific tax implications for your unique situation.

Are life insurance premiums tax-deductible?

Life insurance premiums are not tax-deductible for most people. The Internal Revenue Service (IRS) considers the payments a personal expense, and they are treated the same as any other expense.

However, there are some exceptions to this rule. For example, if you are a business owner, you may be able to deduct the cost of your employees' life insurance premiums as a business expense. The IRS allows for an exclusion of the first $50,000 of group term life coverage offered by some small business owners. If the total benefit of the policy does not exceed $50,000, the small business can deduct the premiums paid on behalf of employees from their taxes.

If you offer your employees more than $50,000 in coverage, the IRS treats the premiums paid for coverage above this amount as employee wages, which cannot be deducted from taxes. It's important to note that you cannot deduct premiums if you or your company are the beneficiary of the policy.

Another instance where life insurance premiums can be tax-deductible is if you have an alimony agreement that went into effect before 2019 that requires you to pay for life insurance on your ex-spouse. Due to tax code changes, tax deductions for alimony payments are no longer allowed for life insurance premiums as of 2019 and later.

If you donate your life insurance policy to a charitable organization, you may also be able to deduct the premiums you pay toward the policy after the date of the donation.

It's always a good idea to consult with a tax professional or a financial advisor to determine if your specific life insurance premiums are deductible and to understand the tax implications of your policy.

Are life insurance dividends taxable?

Whether or not life insurance dividends are taxable depends on the type of policy you have and whether the dividends exceed the total premiums paid.

If you have permanent life insurance from a mutual insurance company, you may receive periodic dividends from the company. With mutual insurance, policyholders are essentially the owners, so the company often distributes excess income in the form of annual dividends. Unless the amount of money you receive in dividends is more than the amount you've paid in premiums, life insurance dividend payments are not taxable.

In most cases, the IRS considers a life insurance dividend to be a return of premiums paid. However, if your dividends are more than the total premiums you've paid into the policy, the excess may be taxable because any dividends over the amount you paid are considered income, not a return of premium.

For example, if you pay $1,000 in life insurance premiums this year and receive a $1,250 dividend, you may owe taxes on the $250 excess.

Additionally, if you leave your dividends in your policy to earn interest, this interest income may be taxable if it earns you more than you've paid in premiums.

Is life insurance taxable when sold?

Life insurance proceeds are usually not taxable as income. However, there are certain situations in which the cash value of a life insurance policy may be taxable.

The cash value of life insurance is generally tax-free. However, there are some instances where you may owe taxes on it. These include:

• Getting a policy loan: If you take out a loan from your life insurance plan, it won't be taxable. However, if the policy terminates before you've repaid the loan, this loan amount may be taxed.
• Cashing out your policy: You can withdraw up to the amount of the total premiums you've paid into the policy without paying taxes. But if you withdraw any gains, such as dividends, they will be taxed as ordinary income.
• Life insurance settlement: If you decide to sell your life insurance policy, a portion of the settlement will be taxed as income, and the rest will be taxed as capital gains.

Life insurance death proceeds are not taxable as income as long as they are paid out as a lump sum. However, they can be considered part of your estate for tax purposes if the total value of your estate exceeds federal and state exemptions.

If your beneficiary is your spouse, the life insurance payout is not taxed and will be passed on to them fully. Spouses typically have an unlimited exemption with regards to estate taxes.

If your beneficiary is anyone other than your spouse, the life insurance payout will be added to the value of your estate. If the total value exceeds the federal and state exemptions, any amount over the exemption will be subject to estate and inheritance taxes.

How to avoid estate taxes on life insurance payouts

One way to avoid having life insurance payouts taxed as part of your estate is to set up an irrevocable life insurance trust (ILIT). However, there are certain situations in which you may still face a tax event:

• Gift tax: If the life insurance policy's cash value is greater than the gift tax exemption when you set up the trust, you may need to pay a gift tax when transferring ownership.
• Three-year rule: If you pass away within three years of transferring the life insurance policy to the trust, the policy will likely become part of your estate from a tax perspective.

Taxes on whole life insurance

Whole life insurance policies are treated differently from a tax perspective because they include a cash value component that grows over time. Each time you pay a premium for a whole life insurance policy, a portion of the premium goes towards the policy's cash value. This cash value is tax-deferred, and you can take a tax-free loan from the insurer using the policy's cash value as collateral, as long as the loan doesn't exceed the cash value.

However, if the loan amount exceeds the cash value, the policy might lapse, and you would have to pay taxes on the loan.

Frequently asked questions