Are Life Insurance Premiums Tax Deductible?
Life insurance premiums are not tax-deductible in most cases. The Internal Revenue Service (IRS) classifies life insurance premiums as personal expenses, like rent or travel expenses, so they don't qualify as a deductible expense.
There are some exceptions, however. Life insurance premiums may be tax-deductible if you are a business owner purchasing coverage for your employees or if you transfer ownership of the policy to a qualified charity.
Why Isn't My Life Insurance Premium Tax-Deductible?
Life insurance premiums are not tax-deductible because they are classified as personal expenses by the IRS. Like paying for rent, purchasing a car or buying food, life insurance premiums do not meet any IRS definition that would qualify it as a deductible expense. If you surrender or cancel a policy for cash, you must include your policy's premiums as taxable income when filing your tax returns with the IRS.
However, there are some exceptions to this rule.
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When Are Life Insurance Premiums Tax-Deductible?
Life insurance premiums may be tax-deductible in some instances where a business or charity is involved.
Life Insurance Premiums for Business Owners
Business owners may deduct business-paid life insurance premiums if:
The premiums purchase coverage for their employees
The business owner or company is not a designated beneficiary of the policy
Other restrictions may apply, as well. We recommend consulting with a business tax expert to ensure you are meeting all of your tax obligations.
Life Insurance as a Charitable Gift
Life insurance premiums may be deductible if you purchase a life insurance policy and then transfer ownership of the policy to a qualified charity. The charity would be the owner and beneficiary, receiving the death benefits when you die.
Despite the charity owning the life insurance policy, you would still be paying for the premiums. When premiums are paid in this way, they may be tax-deductible.
Do You Pay Taxes on Life Insurance for the Accumulated Cash Value?
The accumulated cash value in a life insurance policy is taxable, but accumulates on a tax-deferred basis. Earnings on the cash value will not be taxed until a later date when your beneficiaries receive death benefits following your death.
There are additional tax rules regarding cash value in a life insurance policy when you take out a loan, make a withdrawal or surrender the policy.
Cash Value Loans
Many permanent life insurers allow the insured to borrow against the accumulated cash value in the form of a loan. The loan wouldn't be considered taxable income unless you meet the following two conditions:
The policy lapses or is canceled (because you surrendered the policy).
You have an outstanding loan balance that exceeds the policy basis (the total sum of your premium payments).
For example, let's say that your life insurance policy has a cash value of $100,000. You paid $60,000 in premiums and took out a loan against the policy for $100,00. If your policy lapses, $40,000 would be taxable income because $40,000 ($100,000-$60,000) represents the amount that exceeds how much you paid in premium payments.
Cash Value Withdrawals
A withdrawal from your cash value account would be a taxable event if the withdrawal exceeded the policy basis.
Note: Withdrawals are distinguishable from loans because they liquidate your cash value, reducing the amount in your cash value account. A loan is a lump sum payment issued by the insurance company using your cash value account as collateral.
Surrendering the Policy
When you surrender, or cancel, the policy for cash, any income that exceeds the total sum of premium payments are subject to taxation.
What Are the Tax Advantages of Life Insurance?
Although life insurance premiums are generally not tax-deductible (see exceptions above), there are several tax advantages of purchasing a life insurance policy.
Death Benefits Are Tax-Free
The cash payout (also called death benefits*) issued to your beneficiaries after you die will be tax-free. The beneficiaries will not have to include the death benefits as gross income and will not need to report it to the IRS.
With some death payouts as high as $100,000 and up, this can be a sizable and tax-free lump sum of cash that your beneficiaries will receive. If your beneficiaries were financially dependent on you to survive, then this payout can help them circumvent financial hardship and pay for funeral expenses.
*Note: Cash value is different from the death benefit and will be taxable when issued to your beneficiaries after you die (see above).
Dividends Are Not Taxed if They Do Not Exceed Net Premiums
Some permanent life insurance policies, like a whole life policy, may issue dividends throughout the life of the policy. Generally, dividends are tax-free income but only if the amount does not exceed the policy basis (the total premiums you've paid toward the policy).
For example, say you paid $3,000 in premiums and you've earned $3,500 in dividends. $500 should be reported to the IRS as taxable income because it exceeds your total premium payments ($3,000). If the dividends were reinvested back into the life insurance policy, then the interest earned on the taxable portion would be taxable, as well.
Tax-Deferred Cash Value Growth
When cash value grows tax-deferred, that means that taxes are not paid until the cash value is released — typically when issued to your beneficiaries after you die or if you surrender the policy. Tax-deferred accounts typically grow at a higher rate than a tax-free account (earned income is taxed each year).
Here is an example of the difference in growth between a tax-deferred cash value account included with your life insurance policy versus a tax-free account.
Each account experienced a 3% annual rate of return with $100 monthly contributions over 50 years. Both accounts had a starting balance of $0.
When Is it Required To Pay Taxes on Life Insurance?
Although life insurance death benefits are generally not taxable, the accumulated cash value is. Generally, any amount that exceeds your policy basis is subject to taxation. That means any income your cash value earned past your total premium payments must be reported to the IRS as taxable income.
Below are other scenarios when taxation on your cash value account would apply:
Surrendering the policy for cash: If you surrender the life insurance policy for cash, then any amount higher than the total premiums you've paid into the life insurance policy is taxable.
Policy lapses with an outstanding cash value loan: Any cash value loans that exceed your total premium payments will be subject to taxation but only if the loan is outstanding and you die.
Cash value withdrawals: Any amount that exceeds your total premium payments when you make a withdrawal against your accumulated cash value will be taxable.
If you sell your insurance policy in a viatical settlement, it may be subject to taxation, but not always. A viatical settlement occurs when a life insurance policyholder (usually facing a terminal illness) sells their policy, usually at a discount for a lump sum of cash. Consult a local tax advisor or your State's tax department for more information about the income tax laws surrounding viatical settlements.
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Choosing the Right Life Insurance Policy
There are several tax considerations when purchasing a permanent life insurance policy with a cash value component. The policy is more complex but can have long-term financial benefits for you and your beneficiaries. Conversely, a term life policy offers simple temporary coverage, but with no cash value component.
Each type of life insurance policy has its perks but the right one will depend on your unique situation. SmartFinancial can help you explore coverage options that align with your budget. Just enter your zip code below to receive your free quotes or call 855.214.2291.