Life insurance contracts receive favorable income tax treatment, and premiums may be tax deductible if certain conditions are met. On the same token, life insurance benefits are usually paid tax-deferred to the policy's beneficiaries, yet the benefits may be subject to taxation under certain conditions.
Life insurance tax deduction
Life insurance policies offer several advantages; one of those advantages is a tax-free monetary benefit. It is reassuring to most life insurance policyholders to know their beneficiaries will receive a sum of money to cover their needs, and Uncle Sam can't take it. Given these circumstances, it is only natural that, in most cases, the premiums paid toward life insurance policies cannot be deducted from your taxable income.
On the other hand, there are some circumstances when life insurance premiums may be deducted and certain situations where the benefit amount paid to the policy's beneficiaries may be taxed.
Can life insurance premiums be deducted?
Under most circumstances, life insurance policy premiums cannot be deducted from taxable income when filing your taxes. But there are some conditions in which premiums may be deducted. An easy way to determine if policy premiums may be deducted is to look at typical deductions such as charitable gifts and business expenses.
- Charitable donations. A policy owner can transfer ownership of the policy through assignment. The premiums can be deducted if you assign your life insurance policy to a qualified charitable foundation. Life insurance is most commonly used to provide an estate for the policy's beneficiaries. If you would like to contribute to a charitable cause upon your passing but need the cash on hand, a life insurance policy may be the solution.
- Group life insurance. When an employer sponsors a group life insurance benefit plan for their employees, they own the policy and pay the premiums. The premiums they pay can be deducted as a business expense. However, the employees must be insured and enjoy the policy's benefits, like choosing the beneficiaries. If the policy's benefit amount is more than $50,000, employees must treat $1,000 in excess as taxable income.
- Executive bonus plans. Under a life insurance executive bonus plan, the employer pays all or some of the premiums of a life insurance policy that covers an executive. Employers may deduct the premium payments as employee compensation if the executive includes the employer's premium payments as income.
- Collateral assignment. A creditor may buy a life insurance policy as collateral for the security of a debt. If the borrower passes away before the debt is paid, the creditor can use the life insurance proceeds to cover the debt. Creditors may deduct the premiums from taxable income.
Is whole life insurance tax deductible?
A whole life insurance policy is a permanent life insurance policy that grows cash value. If a whole life insurance policy meets the criteria of any of the bullet points above, premiums may be deductible. For instance, if you are pledging your life insurance policy to a charitable organization, a whole life policy is more sensible than a term life policy that may terminate before you pass away.
It's important to keep in mind that cash value may be taxable. If the policy owner withdraws the policy's cash value as a living benefit, the amount withdrawn that exceeds the total premiums paid is taxable as income.
Is term life insurance tax deductible?
A term life insurance policy terminates at or after a specified time. As with a whole life insurance policy, if the conditions are met to deduct the policy's premiums, term life policies are tax deductible.
For example, it would not be reasonable for a creditor to buy a permanent life insurance policy that covers a debtor as collateral. These types of arrangements are usually handled with decreasing term life insurance. This type of insurance covers debt, which decreases over time, and as it does, so does the cost of the insurance until it reaches zero and terminates.
Considering that some term life insurance riders may be taxable is significant. Term life insurance living benefit riders are arranged to provide financial support if the insured becomes terminally or chronically ill. Two types of living benefit riders include accelerated benefits riders and long-term care riders.
Are life insurance benefits tax-free?
Typically, the death benefit from a personal life insurance policy is not subject to taxation, and beneficiaries do not include the proceeds on their income taxes. However, the rule has some exceptions depending on the settlement method and how the policy was obtained.
Life insurance benefit settlement options that involve proceeds left with the insurer in an interest-bearing account, such as a fixed period settlement option, are subject to taxation.
Under a fixed-period settlement option, the death benefit is paid equally over time. The payments are partly the death benefit amount and the interest earned on the funds that remain in their insurer's account. The interest earned is subject to taxation, while the principal amount of the death benefit is not.
If the death benefit of a life insurance policy is included in the value of the insured's estate, the policy's benefit may be subject to estate taxation.
The death benefit may be taxable when a life insurance policy is transferred for gain or sold to another party. The portion of the death benefit included in the taxable amount is the gain on the policy.
The taxable gain is the amount of the death benefit minus the amount paid to purchase the policy and the premiums paid by the new owner before the insured's passing.
A common question among life insurance consumers is, can you write off life insurance? And the answer is that it depends. Usually, life insurance premiums are generally not tax-deductible, and their benefit amounts are not subject to taxation. But there are exceptions to every rule.
Tips and reminders for tax season
- Stay ahead of tax deadlines. The deadline to file your taxes is April 15th, unless this date happens to be on a weekend or holiday, then the deadline is automatically extended to the next business day. Always check the IRS website for the current year's deadline so you don’t miss it.
- Keep relevant documentation in order. Save any paperwork related to your life insurance policies where it’s easy to find. Make sure those documents include your policy documents, statements of premiums you paid, any notices of taxable events such as cash withdrawals from your policy’s cash value, and proof of any life insurance-related deductions you plan to claim on your return.
Life insurance deduction you may claim
If you've assigned your life insurance policy to a qualified charity, have the charity’s acknowledgment letter and proof of the premium payments you made during the tax year.
If you own a business and pay premiums on policies where the business is the beneficiary on that policy, you will very likely be able to deduct those premiums on your return; make sure you have detailed documentation.
Common mistakes to avoid
Common errors in handling life insurance and taxes can lead to unnecessary complications. Here's what you should avoid this tax season:
- Overlooking taxable events. If you’ve made any cash withdrawals from your life insurance policy's cash value, that may very well be a taxable event, at least in part, if the basis has been exceeded. Have all your documents in hand and review them with your tax professional to make sure any of these transactions are treated appropriately.
- Errors reporting employer-provided life insurance. Remember, if a group life insurance policy is provided for you by your employer, and the benefit exceeds $50,000, those premiums paid by your employer for the excess coverage are considered taxable income to you.
- Not understanding the deductibility of premiums. Life insurance premiums are usually not tax-deductible. However, there are some exceptions, such as policies used for charitable giving or certain types of business arrangements. When you file your taxes, make sure you are not mistakenly deducting premiums on your personal life insurance policy unless you fall into one of the categories that qualify for deductions.
- Not consulting with tax professionals. Life insurance is a complex product, and its role in income taxes is even more so. It's easy to overlook potential deductions or report something incorrectly. Rather than go at this alone, it would be in your best interest to have a tax pro who understands these matters in depth.
Ultimately, staying vigilant and consulting with tax professionals, if necessary, to ensure accurate reporting and compliance will help maximize your financial benefits.
A simple way to evaluate if your life insurance policy's premiums may be tax deductible is to consider if its use is similar to typical deductions such as charitable gifts and business expenses.
Both whole and term life insurance follow the same criteria to determine if premiums are tax deductible; however, living benefits may be subject to taxation.
The benefit of the life insurance policy is usually paid on a tax-deferred basis. But some conditions cause the payments to be subject to taxation, such as the interest accumulated on the benefit amount and estate taxes.
- Bankrate. Taxes on life insurance: Here's when proceeds are taxable.
- American National. Section 162 Executive Bonus Plan.