Life insurance is a financial product that pays out a lump sum in the event of the insured's death, providing financial support to one's beneficiaries and heirs. The death benefit coverage remains in-effect so long as the policyholder pays the insurance premiums (payments) on the policy. The premiums owed for a policy will depend on the insured's age and health (the younger and healthier, the less expensive), along with the size of the death benefit and whether or not it is term or permanent coverage. Because life insurance is intended to support one's beneficiaries, the IRS treats it differently from other types of financial products.
It is important to consider the tax implications when you're buying life insurance. The Internal Revenue Service (IRS) imposes different tax rules on different plans, and sometimes the distinctions are arbitrary. The following guide is meant to help explain some of the tax implications surrounding life insurance premiums.
- Under most circumstances you don’t pay a sales tax on life insurance premiums. However, states typically charge insurers a tax on the premiums they collect.
- You cannot deduct life insurance premiums from your income taxes.
- If your employer pays for a life insurance, the premium paid on policy amounts above $50,000 is considered part of your taxable income.
- Interest generated from whole life insurance policies are not taxed until the policy is cashed out.
Understanding Life Insurance
A person shopping for life insurance has many things to consider before making a decision. First, there is the distinction between term life insurance and whole life insurance. Term life provides coverage for a set number of years, while a whole life policy is effective for life. A policyholder also must calculate how much coverage they need. This depends largely on why they are buying life insurance.
If you are only concerned with covering your own burial and funeral costs for your next of kin, you may opt for a death benefit of $20,000 or less. By contrast, if you have several dependent children, all of whom you hope to send to college in the future, you would probably want $500,000 or more in coverage. Further complicating the buying process is the sheer number of life insurance companies from which to choose. The internet has made this process somewhat easier, with several sites dedicated exclusively to comparing quotes from dozens of life insurance companies side by side.
Unlike buying a car or a television set, buying life insurance does not require the payment of sales tax. This means the premium amount you, as the policyholder, are quoted when you obtain coverage is the amount you pay, with no percentage amount added to cover taxes.
That said, states typically charge a tax based on the premiums they collect, which vary by state, and that is likely passed onto the consumer. For example, Alabama charges a premium tax on life premiums that ranges between 0.5% and 2.3%.
Employer-Paid 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.
If, for example, an employer provides an employee, for the duration of their employment, with $50,000 in life insurance coverage in addition to their salary, health benefits, and retirement savings plan, the employee doesn't have to pay taxes on the life insurance benefit because it does not exceed the threshold set by the IRS.
Alternatively, if a employer pays for a $100,000 life insurance policy, the employee must pay taxes on part of that amount. The taxable amount is based on IRS tables, regardless of the actual premium paid. For example, a 70-year-old receiving $50,000 in insurance coverage above the threshold is considered to have $103 per month in additional taxable income, or $1,236 per year.
Prepaid Life Insurance
Some life insurance plans allow the policyholder to pay a lump sum premium upfront. That money gets applied to the plan's premiums throughout the plan's duration.
The lump-sum payment also grows in value because of interest. The growth of that money is considered interest income by the IRS, which means it can be subject to taxation when it is applied to a premium payment or when the policyholder withdraws some or all of the money they have earned.
Life insurance premiums—which are classified as a personal expense by the IRS—cannot be deducted on your federal tax return.
Cash Value Plans
Many whole life insurance plans, in addition to providing the insured with a fixed death benefit, also accumulate cash value as policyholders pay into the plans with their premium dollars. A portion of the premium dollars enters a fund that accumulates interest. It is common, particularly with plans that have been in force for many years, for the cash value to exceed the amount the policyholder has paid in premiums. People use this type of life insurance as an investment vehicle along with taking advantage of the protection it provides their families in the event of an untimely death.
Many financial advisers remain steadfastly against using life insurance for investment purposes, claiming the returns, historically, have been extremely weak compared to mutual funds and other investments. Nonetheless, the fact remains that the cash value of most whole life insurance policies grows over time. Because this is considered income to the policyholder, it has income tax implications.
The Tax Consequences
The good news for a whole life policyholder is they don't have to pay income taxes each year on the growth in their plan's cash value. Similar to retirement accounts, such as 401(k) plans and IRAs, the accumulation of cash value in a whole life insurance policy is tax-deferred. Even though this money qualifies as income, the IRS does not require a policyholder to pay taxes on it until they cash out the policy.
If and when a policyholder elects to take the cash value of their whole life insurance policy, the amount they are required to pay taxes on is the difference between the cash value they receive and the total they paid in premiums during the time the policy was in force. If, for example, they pay $100 per month for 20 years, or $24,000, and then cash out the policy and receive $30,000, the amount subject to taxes is $6,000.
Another feature of whole life insurance is that, in many cases, the policyholder is allowed to take out a loan against the cash value of the policy. There is a misconception that the proceeds from this kind of loan are taxable. That is not the case, even when the loan amount exceeds the total premiums paid into the policy.
Taking out a loan reduces the death benefit value of the policy until it is repaid (along with any interest owed).
When Are Life Insurance Premiums Tax-Deductible?
Life insurance premiums are not usually tax-deductible. You may, however, be able to deduct them as a business expense if you are not directly or indirectly a beneficiary of the policy. Also, if you are divorced and your divorce agreement was executed prior to 2019, any life insurance premiums you pay as part of that agreement is considered alimony and can be deducted from your income taxes.
Are Life Insurance Death Benefits Taxed?
Life insurance proceeds you receive as a beneficiary are not included in your income and do not need to be reported to the IRS. However, life insurance proceeds are taxable when included as part of your estate and if you meet the $12.9 million filing threshold.
Are Withdrawals from Permanent Life Insurance Taxed?
Cash-value life insurance has certain tax advantages. One of them is that withdrawals made from the policy are considered a return of premiums already paid, and are therefore not subject to taxation. However, if you withdraw all of the value of the premiums you paid in and you begin withdrawing gains from interest or dividends, those dollars would then be taxed as income.
The Bottom Line
Life insurance premiums are not usually subject to sales tax, and they are also not tax-deductible under most circumstances. There are, however, 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.