Are you wondering if paying life insurance premiums is tax-deductible? Or maybe you are a life insurance policy beneficiary and wondering if you’ll eventually be taxed on the death benefits? Are you a business owner providing group life insurance for your employees, and wondering if that expense is deductible?
This article will set forth the tax implication of life insurance for all three parties from the perspective of a respected national life insurance beneficiary attorney.
Life Insurance Premiums for Individuals Insuring Themselves
Tax Treatment of Term Life Insurance Policies
The Internal Revenue Service (IRS) considers life insurance premiums as a personal expense, like a cell phone payment or a car loan payment, therefore, life insurance premiums are not tax-deductible for individuals.
However, if you are a child support obligor or alimony obligor, and you have been ordered to maintain life insurance in order to ensure that income stream for the support obligee, your premium payments are tax-deductible.
Tax Treatment of Whole or Permanent Life Insurance Policies
An individual paying their own premiums on any type of life insurance policy may not take that tax deduction.
However, if you purchased a whole life insurance policy (also called “permanent” or “universal” life insurance), interest earned and any other returns from that investment are taxed as interest income. That tax is not levied until you cash the policy out.
Compare Life Insurance Policies
Prepaid Life Insurance Premiums
Some life insurance plans allow the insured to pay a lump sum in premiums at the time of purchase. This means the insurer deducts premiums from that sum as they come due, throughout the term of the policy. Meanwhile, the initial lump-sum payment grows in value because of interest. The growth of that money is considered interest income by the IRS, which means it is subject to federal taxation when it is withdrawn and applied to a premium payment, or when the insured decides to withdraw some or all of the money earned in interest. However, if withdrawals do not exceed the amount deposited by the insured, there is no federal tax liability.
Life Insurance Death Benefit Tax Liability
Generally speaking, a beneficiary to a life insurance policy does not pay federal income tax on the death benefit. There are two exceptions to this rule:
1. If the beneficiary asked that the insurance company hold the death benefit for a few weeks or months after it became payable, any interest earned during that time is taxable to the beneficiary.
2. If the policyholder named his or her estate as the beneficiary, this exposes the heirs to a high federal estate tax of 40%, but only for estates that exceed $11.58 million in 2020. If your estate meets or exceeds that amount, and you are a policyholder and want your estate to receive the death benefit, you can avoid estate taxes by transferring ownership of the policy to someone else. Then you can provide for premium payments by gifting that amount to the new owner of the policy. In 2020, the annual gift limit is $15,000.
3. Be aware when selecting a new owner of your life insurance policy that it cannot be a minor. If you select your spouse as the new owner, know that transfer of ownership is irrevocable, so if you later divorce you cannot change it. Also, if you die within three years of the ownership transfer, the death benefit is taxable as if you remained the owner.
Deduction of Group Life Insurance For Employees
If an employer pays life insurance premiums on an employee’s behalf, any payments for coverage of $50,000 or more are taxed as income to the employee. You as the owner of the business cannot be named directly or indirectly as the beneficiary of these policies. You can deduct the amount paid in premiums up to that which pays for $50,000 in coverage per employee. Your employees will pay federal income tax on the amount of premium you paid on their behalf that exceeds the amount of premium that would purchase $50,000 worth of coverage. For example, if you pay $120 a month for $100,000 in coverage and $50,000 in coverage would cost $75 a month, your employee will pay income tax on $45 a month.
How Small Business Owners Can Save on Federal Income Tax and Save for Retirement
A 412(i) plan is a qualified defined-benefit plan which can provide substantial tax deductions for small-business owners looking to catch up on their retirement savings. This particular plan is funded with insurance policies such as a cash value life insurance policy or a fixed annuity contract. You as a plan owner can deduct hundreds of thousands of dollars in pre-tax contributions to these accounts annually.
For more information on the federal tax treatment of life insurance premiums and proceeds, individuals can consult IRS Publication 502. Business owners can consult IRS Publication 535.
