Most of us know that life insurance is an important financial planning tool, but questions like “Is life insurance taxable?” require discussion with a financial advisor. Tax rules are complex and, as life insurance products continue to evolve, the line separating some life insurance types from other investment vehicles is sometimes blurred.
To distinguish between life insurance and investments, the IRS regulations offer a mixed bag. You’ll need to understand complex tax rules along with exceptions regarding taxation of some insurance products in certain situations.
Is Life Insurance Taxable: IRS Requirements
For purposes of federal taxation, your insurance contract must meet specific IRS statutory definitions of life insurance in order to receive favorable tax treatment. To determine if your contract qualifies, the IRS considers:
- Premiums paid
- Type of policy
- Issue date
- Death benefit amount
IRS definitions of life insurance serve as verify that your contract isn’t actually an investment. To ensure that your life insurance isn’t taxable, the insurer must comply with IRS’s rules and take steps to enforce them.
Premiums aren’t deductible on a federal tax return. The Internal Revenue Service says that life insurance premiums for direct pay life insurance are a personal expense.
In contrast, life insurance contracts paid by your employer may have a tax basis. Your tax cost for the first USD 50,000 of life coverage paid for by an employer doesn’t need to be reported as income. You aren’t taxed on this amount. If you receive additional employer-paid coverage, it may trigger a taxable event because IRS says you receive economic benefit from it.
Is Life Insurance Taxable: Premium Payments
Life insurance payments can be made with after or pretax dollars. If you buy life insurance directly from an insurer or from an employer group plan, premiums are usually paid in after-tax funds:
- Different IRS rules may come into play if your employer offers an option to buy life insurance via a qualified retirement plan to which you make pretax contributions.
- Pretax contributions may offer the advantage of reducing your total taxable income, but tradeoffs can occur when the economic value of the policy’s pure life insurancevalue, the difference between the policy cash value and death benefits, are considered each tax year.
- At death, your policy cash value that’s paid as a portion of the death benefit would be considered taxable.
Fortunately, few employers offer the option to buy life insurance from a qualified retirement plan. Unless yours does, a beneficiary of your life insurance won’t pay taxes on the death benefit received.
Is Life Insurance Taxable: Death Benefit Proceeds
The beneficiary of your life insurance policy isn’t required to pay federal and/or state taxes on the proceeds in most cases. If you die and your life insurance policy pays a death benefit of $1,000,000, the beneficiary won’t pay income tax on the money:
- IRS rules say your beneficiary won’t pay taxes on the money if you paid the policy premiums yourself or if an employer made partial or all premium payments for your policy as part of a group term insurance plan.
- Different IRS rules apply if the recipient receives the death benefit in installment payments. In that case, the interest portion of an installment is considered taxable as ordinary income. The principal is considered tax-free.
Unfortunately, in some instances insurance proceeds might be included in a taxable estate.
Is Life Insurance Taxable: Your Taxable Estate
Holdings of incidents of ownership can cause proceeds from the insurance policy to be added to your taxable estate. Incidents of ownership include the right to:
- Change policy beneficiary
- Take out policy loans
- Surrender a policy for cash
If you give your insurance policy to anyone else within three years of death, the proceeds of the policy are considered part of the taxable estate. To avoid this problem, someone else—a trust or a beneficiary—should own the policy.
- Note that if the owner, beneficiary, and insured are three separate individuals, payment of the policy’s death benefit proceeds can trigger a taxable gift event from owner to beneficiary.
Is Life Insurance Taxable: Cash Value and Dividends
Unlike a term life policy, some life insurance types, such as whole life insurance, build cash value. As the cash value component grows, the policyholder can have more funds in cash value than paid in premiums.
- In most cases, IRS allows you to defer current taxes on the gains if you don’t sell, surrender, or withdraw from a policy.
- If you sell, withdraw from, or surrender it, the difference between what you paid in and what you received is taxable as ordinary income.
You won’t usually pay taxes on participating policy dividends. Insurance dividends are return of capital, a part of your premium that’s returned to you when the insurer’s customers achieve lower mortality rates and expenses than it anticipated. Dividends are paid from the company’s annual surplus earnings:
- You can keep paid dividends in cash, hold them in your insurance account, or purchase more life insurance in your policy.
- If you don’t receive more money than paid in premiums, IRS says you’re recovering costs. No tax event occurs.
- If you deposit the dividends with the insurer and earn later interest on these funds, interest received may be considered as taxable income.
Is Your Life Insurance Taxable
As you can see, tax rules concerning life insurance are complex. Ask a financial advisor you’re wondering about the tax impact of your life insurance.