How Do Taxes Work with Life Insurance?
The decision to purchase life insurance is an essential one. Appropriate life insurance coverage provides peace of mind and security. Nevertheless, there are several factors involved during the decision-making process. One such factor is taxes on life insurance premiums.
On the whole, various rules apply to life insurance. Therefore, this article will focus on discussing life insurance taxes. Moreover, this article will discuss how the Internal Revenue Service (IRS) taxes life insurance policy returns.
What is Life Insurance?
There are two main types of life insurance. As such, it’s crucial to recognize the difference before choosing the best policy for your needs.
Term Life Insurance
Firstly, term life insurance provides coverage for a specified timeframe. Generally speaking, term life insurance lasts for ten-year blocks. Most term life insurance policies last for ten years, with the option for renewal after that.
Term life insurance often carried a fixed premium based on the policy’s total value. If the policyholder dies while the policy is valid, the beneficiaries receive the full payout. If the policy expires, its renewal will imply a recalculation of premiums.
Please keep in mind that term life insurance doesn’t generally have any additional benefits. Consequently, it only pays out its cash value. If the policy expires, there is no cash payout. Additionally, term life insurance payouts to beneficiaries are not taxable.
Whole Life Insurance
Secondly, whole life insurance policies cover the policyholder until their death. Whole life insurance does not generally have a fixed timeframe and does not require policy renewal. The policy pays out to beneficiaries at the time of the policyholder’s death.
However, whole life insurance varies significantly from term life coverage. In particular, whole life insurance accrues a savings component. In other words, insurers credit premium payments toward a savings plan. Naturally, younger policyholders can contribute more toward their policy’s savings.
Insurers may attach an interest rate to the policy’s saving component. This interest rate compounds over time, thereby leading to the policy’s cash value. These policies don’t generally pay out interest. Interests roll over until the policyholder cashes out the policy.
In some instances, policyholders use whole life insurance as an investment. As they get older, they sell their policy for its cash value. Afterward, the policyholder can purchase term life insurance if they desire. Insurers may choose to buy back the policy and payout interests.
Please bear in mind that accrued interest is taxable. Nevertheless, this interest is tax-deferred. Thus, the tax bill only comes until the policyholder cashes out.
How do I Choose the Best Policy for My Needs?
Generally speaking, older individuals prefer term life insurance, especially if they have chronic medical conditions. Plus, the fixed premium allows policyholders to plan their finances accordingly. In contrast, younger individuals prefer whole life insurance since they can accrue interest over time.
Additionally, premiums are an important consideration. For instance, term life insurance policies are cheaper than whole life. A term life policy for $250,000 may cost around $20 to $30 monthly. Conversely, a whole life policy may cost up to $100 a month.
Fortunately, whole life insurance premiums often decrease over time. Nevertheless, some whole life policies may expire at a specific age. For example, the policy automatically expires at 65 or 70. At that point, the policyholder would need not receive the death benefit. They would only receive their interest payout.
The reason above explains why older policyholders choose to sell their policies before the age of expiration. Consequently, you must double-check your policy before signing on. In doing so, you can avoid unpleasant surprises after signing on.
Do You Pay Taxes on Life Insurance Premiums?
Taxes on life insurance boil down to taxable income. Policyholders don’t need to pay taxes until they profit from their policy. In other words, the “policy basis” or the policy payout amount is not subject to taxes.
However, policyholders must pay taxes when they generate income from their policy.
Consider this situation:
A policyholder no longer wishes to keep their coverage. As such, the policyholder surrenders their coverage. In this situation, the insurer ends the contract and returns the premium payments to the policyholder.
This transaction does not generate any taxes unless the policyholder receives an amount greater than their premium payments. For instance, the policyholder paid $10,000 in premiums. As such, those $10,000 are not taxable.
In contrast, if the policyholder receives $10,000 plus $1,000 in accrued interest, the policyholder would need to pay taxes on the $1,000. After all, the IRS considers interest payments as income. Therefore, the policyholder would need to pay the corresponding income taxes.
Withdrawing from the Policy’s Cash Value
Some policies allow policyholders to make loans on their policy’s cash value. Typically, this type of loan is tax-free as long as it’s within the policy limits.
For example, if the policy has a $250,000 cash value, the policyholder can borrow up to $250,000. The IRS does not consider this loan as income. Therefore, the policyholder is not liable for taxes on it.
Conversely, if the policyholder takes out the $250,000 as a loan plus $1,000 worth of interest, the $1,000 may be taxable. The $1,000 would not technically be a loan as it constitutes earned interest. Thus, the IRS considers it income and not a loan.
Selling your Life Insurance Policy
In some instances, you might consider selling your life insurance policy. Selling policies is relatively common, especially for ill patients who need to cover medical bills. There are investment firms that specialize in purchasing life insurance policies.
The good news is that the IRA does not tax “viatical settlements.” A viatical settlement consists of a terminally ill individual selling their policy to cover outstanding bills. In such cases, the proceeds from the sale are not taxable.
Please bear in mind that the IRS treats viatical settlements as death benefits. However, if the policyholder is not terminally ill, proceeds from the sale of the policy may be taxable. The IRS considers this transaction as a “life settlement.” The taxable portion would correspond to any value above the policy’s cash value.
Policy Payouts Go into a Taxable Estate
Insurance payouts go into the policyholders ‘ estate when the policyholder names no beneficiaries or is already deceased. As such, the policyholder’s estate receives the payout and is therefore liable for a sizeable tax bill.
In contrast, named beneficiaries do not have to pay taxes on the death benefit received. Consequently, it’s to name beneficiaries to claim the policy. In doing so, beneficiaries can avoid paying state and federal taxes.
Is There a Life Insurance Tax?
No, there isn’t a “life insurance tax.”
In short, life insurance premiums are not subject to regular sales taxes. As such, you don’t need to add the sales tax on top of your monthly. So, if your payment is $25 monthly, you pay $25. Nevertheless, there are situations in which you may need to pay taxes on your premiums.
So, let’s take a look at when you would need to pay taxes on your premiums.
Life Insurance as Compensation
When your employer offers life insurance as part of your compensation, you must pay taxes. Technically, the IRS calculates employer-paid premiums as part of your income. As a result, you would be on the hook for income tax.
There is a catch, though. You’re liable for taxes only if your employer offers more than $50,000. As such, you wouldn’t need to pay taxes on coverage under $50,000. You would need to pay coverage on anything over $50,000.
In contrast, if the employer offers a $100,000 with a $50 monthly premium, you would need to pay taxes on half of the policy ($50,000). Consequently, you would need to pay taxes on half of the monthly premium ($25).
Pre-paid Life Insurance
In some instances, policyholders need to make a lump sum, upfront payment. This payment goes toward the policy’s premium. Moreover, this upfront payment may generate interest. Consequently, the IRS considers interest as income.
Please bear in mind that you don’t have to pay the taxes until you collect the interest. Therefore, your interest payment becomes taxable income every time you cash out.
Whole Life Insurance Cash Plans
The interest that whole life insurance policies accrue is generally tax-deferred. As such, the policyholder isn’t liable for the tax payment until they cash out the policy. However, the policyholder would need to pay taxes on the premium if it is part of their compensation.
Are Life Insurance Premiums Tax-Deductible?
The short answer to this question is no.
The IRS considers life insurance premiums as personal expenses. As a result, life insurance premiums are not tax-deductible. Moreover, the IRS does not consider life insurance premiums as a business expense.
After all, the policy benefits belong to the policyholder and not the business. Therefore, you cannot claim your life insurance premiums as a business expense.
Bringing It All Together
There are various circumstances surrounding life insurance taxes. As such, the following table summarizes the scenarios in which you may or may not have to pay taxes on a life insurance policy.
|The policyholder withdraws money from the policy’s cash value.||Any amount over the policy’s cash value would become taxable income.|
|The policyholder surrenders the policy in exchange for a cash payout.||Any amount over the policy’s cash value would become taxable income.|
|The policyholder takes out a loan based on the policy’s cash value.||There is no tax liability as long as the policy is current. If the coverage ends, the IRS may consider the outstanding balance as taxable income.|
|The policyholder sells the policy in a viatical settlement.||There is no tax liability as long as the policyholder is terminally ill.|
|The policyholder sells the policy in a life settlement.||Any amount over the policy’s cash value would become taxable income.|
|The policy’s payout goes into the policyholder’s estate.||There is tax liability on the overall estate, including the life insurance payout.|
|The policy’s beneficiaries receive the policy’s payout.||There is no tax liability for the death benefits. However, the beneficiaries do have a tax liability on accrued interest payments.|
On the whole, life insurance is not taxable. Nevertheless, there are various situations in which life insurance policies are taxable. Therefore, policyholders must be aware of these circumstances.
Life insurance policy premiums are not taxable. Additionally, premiums are not tax-deductible as the IRS considers their personal expenses. Furthermore, life insurance premiums are taxable when they are part of a compensation package.
Please remember that life insurance payouts are not tax-deductible when they are death benefits. However, interest payments on life insurance policies constitute taxable income. The good news is that taxes are due only when policyholders cash out interest.
Lastly, it’s important to note that policyholders may have a tax bill due upon selling their policy. Thus, it’s crucial to double-check before selling the policy. In doing so, there won’t be any unexpected tax bills down the road.
- Life insurance premiums are not taxable. Premiums are not subject to sales tax. However, life insurance premiums are not tax-deductible. The IRS considers life insurance premiums as personal expenses. Consequently, policyholders cannot claim premiums on their return.
- Premiums may become taxable income when employers pay them as part of employee compensation. Employees would need to pay taxes on their premiums when the policy’s value is over $50,000. The IRS considers these premiums as part of an employee’s taxable income.
- Accrued interest on a policy’s premiums constitutes taxable income. Consequently, the policyholder would need to pay taxes on the earned interest. However, earned interest is tax-deferred. Therefore, the policyholder needs to pay taxes only when they collect the interest payment.
- Beneficiaries do not need to pay taxes on the policy’s payout. The policy’s cash value is tax-free. Nevertheless, any amount above the policy’s cash value constitutes taxable income. Moreover, suppose the policy’s payout goes into the policyholder’s estate. In that case, there may be state and federal taxes due on the entire estate, including the policy payout.
Zach Richter has been writing professionally for just shy of 20 years. Typing that sentence made him feel old. He lives in Arizona with his wife and too many dogs and cats.
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