You Could Owe Uncle Sam Money!

Life insurance is a financial product that pays a beneficiary a lump sum upon the insured person's death, providing financial support to beneficiaries and heirs. Death benefit coverage remains in force as long as the owner pays the insurance premiums.

A policy's premiums depend on the insured person's age and health—the younger and healthier, the less expensive—along with the size of the death benefit and whether coverage is term or permanent. Because life insurance is intended to support beneficiaries, the IRS treats it differently from other financial products.

Life insurance

Someone buying life insurance has many things to consider before deciding. First, there is the distinction between term life and whole life insurance. Term life insurance provides coverage for a set number of years, while a whole life policy lasts a lifetime.

If your only concern is covering your own burial and funeral expenses for your immediate family, you may choose a death benefit of $20,000 or less. By contrast, if you have several dependent children whom you hope to send to college, you will probably want $500,000 or more in coverage. The large number of life insurance companies to choose from further complicates the purchasing process. The internet has made it somewhat easier, with several sites devoted exclusively to comparing quotes from dozens of life insurance companies side by side.

Certain situations require an insured person to pay taxes on insurance premiums

Unlike buying a car or television, purchasing life insurance does not require paying sales tax. This means that the premium quoted to you as the policy owner when you obtain coverage is the amount you pay, with no added percentage for taxes. That said, certain situations require an insured person to pay taxes on insurance premiums.

Employer-paid life insurance

When an employer provides life insurance as part of an overall compensation package, the IRS considers it income, meaning the employee is subject to tax. However, these taxes apply only when the employer pays for more than $50,000 in life insurance coverage. Even then, the premium cost for the first $50,000 of coverage is tax-exempt.

If an employer provides an employee with $50,000 in life insurance coverage for the duration of employment, in addition to salary, health benefits, and a retirement savings plan, the employee does not have to pay taxes on the life insurance because it does not exceed the IRS threshold.

Alternatively, if employer-provided life insurance coverage is $100,000, the employee must pay taxes on part of it. The premium dollars paying for the $50,000 in coverage above the IRS threshold count as taxable income. Therefore, if the monthly premium is $100, the taxable amount is the portion paying for the additional $50,000 in coverage, or $50.

Prepaid life insurance

Some life insurance plans allow the owner to pay a single premium in advance—a lump sum—that is applied to premiums over the plan's duration. This lump sum also earns interest. The IRS considers that interest a “gain,” and it must be taxed when applied to a premium payment or when the policy owner withdraws some or all of the money earned.

Life insurance premiums, which the IRS classifies as personal expenses, cannot be deducted on your federal tax return.

Cash value plans

Many whole life insurance plans, in addition to providing a fixed death benefit, accumulate cash value as policyholders fund them through premium payments. A portion of premium dollars goes into a fund that earns interest. Particularly in plans that have been in force for many years, cash value commonly exceeds the amount the owner has paid in premiums.
People use this type of life insurance as an investment vehicle while also benefiting from the protection it provides their families in the event of premature death.

Despite the fact that cash value in most whole life insurance policies grows over time, many financial advisors oppose using life insurance for investment purposes, arguing that returns have historically been extremely low compared with mutual funds and other investments.

Tax consequences

The good news for whole life policyholders is that they do not have to pay income tax each year on their plan's cash value growth. As with retirement accounts, 401(k) plans, and IRAs, cash value accumulation in a whole life insurance policy is tax-deferred. Although this money qualifies as income, the IRS does not require the policy owner to pay tax on it until they cash in the policy.

When a policy owner takes the cash value from their policy, the taxable amount is the difference between the cash value and the total premiums paid while the policy was in force. For example, if they pay $100 per month for 20 years, or $24,000, and then cash in the policy and receive $30,000, the taxable amount is $6,000.

Another feature of whole life insurance is that, in many cases, the policy owner can borrow against the policy's cash value. However, taking a loan reduces the policy's death benefit until it is repaid, along with any interest owed.

When are life insurance premiums tax-deductible?

Life insurance premiums are usually not tax-deductible. However, you may be able to deduct them as business expenses if you own a business that has purchased life insurance coverage for key employees or as part of a buy-sell agreement.

You may also be able to do so if you divorced before 2019 and have a court-ordered life insurance policy; these premiums may also be deductible.

Are life insurance death benefits taxed?

Life insurance provides beneficiaries with a tax-free death benefit. However, it may be subject to estate tax if the combined estate value, including the death benefit, exceeds the tax threshold.

Are permanent life insurance withdrawals taxed?

Cash value life insurance has certain tax advantages. One is that policy withdrawals are considered a return of premiums already paid and are therefore not taxable. However, if you withdraw the full value of the premiums you paid and begin withdrawing interest or dividend earnings, those dollars would be taxed as income.

Life insurance premiums are generally not subject to sales tax and are not tax-deductible in most circumstances. However, certain situations cause the IRS to treat life insurance premiums differently, resulting in tax consequences. These situations arise most often when a business owns or pays for the life insurance policy.