Life insurance policies demand a premium in exchange for providing protection. When selecting a new policy, the monthly premium payment is typically a major consideration. And such premiums may result in additional tax advantages.
But are the costs of life insurance tax deductible? Here's how to negotiate your policy's potential tax repercussions.
What is a tax deduction?
A tax deduction decreases your taxable income. Although many circumstances require a standard deduction, you should probably use the itemized deduction if it exceeds the standard deduction. For instance, you might be allowed to use form 1040, Schedule A, to claim an itemized deduction for some donations to acceptable charitable organizations.
Are the costs of life insurance tax deductible?
Life insurance premiums are typically not tax deductible. There are a few exceptions to this rule, though. For example, some companies allow for the deduction of insurance payments paid on behalf of employees.
Tax deductions for life insurance premiums may apply in the following circumstances:
Term life insurance for groups: According to the IRS, some small business owners may sell group term life insurance with a $50,000 maximum exclusion. Over $50,000 and the insurance cost must be included in income and subject to Social Security and Medicare taxes, according to the policy's maximum total benefit amount. When this occurs, the small business can write off the employee premiums as a tax deduction.
Donating life insurance to a good cause: A tax advantage may be obtained by giving your life insurance policy to a nonprofit organisation. Both the premiums you paid into the policy and the premiums paid after the transfer may be tax deductible when you give your insurance to a qualified charity. Note: If the premium is paid directly to the insurance provider rather than to the charity, the amount of the premiums that may be deducted after gifting the policy to the charity may change.
Bonus Plans for Executives: If a key executive reports the premium payment as taxable income, the business owner may be allowed to deduct the premiums for an individual life insurance policy on that individual.
Dated alimony contracts: Prior to 2019, spouses who were ordered to purchase life insurance as a condition of an alimony agreement might be able to deduct the cost of those premiums from their taxes. Tax deductions for alimony payments are no longer permitted for life insurance premiums beginning in 2019, however, as a result of changes to the tax code brought about by The Tax Cuts and Jobs Act.
Are death benefits from life insurance taxable?
Death benefits from life insurance are often tax-free. Beneficiaries may receive a payout that is income tax-free and can be used any way they like if the policy owner passes away while the insurance is still in effect. Having said that, the following matters should be noted:
Installment-based payment of death benefits: A beneficiary may produce some taxable income if they opt to receive the death benefits in installments. However, this is only applicable to sums greater than the death proceeds, determined by the settlement choice the beneficiary makes.
Estate charges On gifts and estates, the IRS permits a lifelong tax exemption. This cap is adjusted annually for inflation. For 2022, the exemption from estate taxes is $12,060,000. As life insurance proceeds are regarded as a component of a beneficiary's taxable estate, they can be subject to estate tax if the amount is greater than the policy owner's lifetime exclusion at the time of his or her passing. Even though this differs from income tax, it is still something to consider.
Rule of transfer for value: Some insurance companies can let you trade anything of value for your life insurance policy and sell it to someone else (i.e., money, a property or other valuable item). In those circumstances, if there is no exception, a portion of your death benefit would subsequently be taxed as ordinary income.
How is the cash value of life insurance taxed?
While it is still a cash-value component of the policy, the cash value of permanent life insurance is not subject to taxes. In other words, the increase is tax-deferred as long as your cash worth increases in the insurance.
You will have to pay taxes on the interest earned if you decide to surrender your insurance or choose to take money out of your cash value. In general, partial surrenders will first be viewed as income received from the insurance and then as a non-taxable recovery of premium. Because of this, unless it exceeds the investment in the policy just before the partial surrender, a partial surrender from a policy won't normally be considered income. If your policy isn't a modified endowment contract or MEC, that is.
Tax ramifications are different when dealing with a MEC. Distributions from the policy, including loans and partial surrenders, will be handled as a recovery of investment in the policy first and then as an income withdrawal.
Before the age of 59 1/2, distributions, including loans and partial surrenders, may additionally be subject to a 10% penalty on the percentage of the proceeds that is taxable. MEC death payouts, however, continue to be tax-free, just like those from non-MEC insurance policies. Ask your insurance provider about the annual limits on premium additions if you're worried your policy will end up as a MEC.
Let's use a non-MEC case where you have a whole life insurance policy with a cash value of $20,000. Then, you choose whether to take the cash value or cancel the insurance coverage. You would pay tax on the $5,000 in interest but not on the remaining $15,000 in premiums if you had paid $15,000 in premiums and $5,000 represented the interest.
To sum up
Before picking an insurance policy, it's a good idea to ask plenty of questions about how taxes may affect different policies. Choosing the proper insurance policy entails much more than simply looking for the lowest cost.
Are the costs of life insurance tax deductible? Is the growth of cash value tax-deferred? Are the distributions from your policy taxable? A financial advisor can assist you as you understand the complex guidelines and exclusions related to life insurance taxation.