Tax advantages are one of the main reasons individuals decide to purchase whole life insurance over other insurance products, but it’s important to understand how taxes and life insurance work together. Which components of a life insurance policy are taxable and how can you use life insurance to pay less taxes? Is life insurance taxable for your beneficiaries? Here are all the answers to the most commonly asked questions about life insurance and taxes.
Everything You Need to Know About Life Insurance & Taxes
Are life insurance premiums tax deductible?
Life insurance premiums are paid with after-tax dollars and aren’t tax deductible. There is an exception for employers who pay for group life insurance for their employees. In this instance, employers may deduct premiums that purchase up to $50,000 of life insurance coverage for each employee, provided the employer is not named as a beneficiary on any of the policies. There may also be exceptions for certain legal implications, like if you pay insurance premiums as part of an alimony settlement.
Is life insurance taxable for my beneficiaries?
Life insurance usually isn’t taxable for your beneficiaries. It’s one of the benefits of having insurance; it protects your family and provides tax-free income when they need it most. If your death benefit is paid in one lump sum, your beneficiaries don’t need to report it on their income taxes. However, there are a few instances when life insurance is taxable for loved ones:
If a death benefit is paid as an annuity:
If your beneficiary isn’t paid out in one lump sum and instead receives your death benefit as a series of payments, it may be considered taxable income. If the unpaid portion of the death benefit continues to earn interest before it’s paid out, the interest is taxable and should be reported on annual income tax statements. If this applies to your beneficiary, they should receive IRS Form 1099-INT from your insurance company to file with their taxes.
If your beneficiary meets certain income thresholds and is receiving a death benefit in payments, they may be subject to an additional tax called a net income investment tax. This applies to single individuals earning a modified adjusted gross income of $200,000 or higher and married couples filing jointly earning a modified adjusted gross income of $250,000 or higher.
If you have a large estate:
As of 2021, estates valued at $11.7 million or more are subject to federal estate taxes. While any death benefit paid out to a spouse or child beneficiary is typically tax-free, any life insurance payable to your estate is subject to taxes. This can be especially problematic for policyholders who own large amounts of life insurance that would push the value of their estate over the federal $11.7 million threshold. In addition to federal estate taxes, some states also impose their own estate taxes on estates valued as low as $1 million.
The following states impose estate taxes:
- District of Columbia
- New York
- Rhode Island
If you live in a state with inheritance taxes:
A handful of states impose inheritance taxes on payouts from life insurance policies. Spouses are exempt from inheritance taxes, but children and domestic partners are not. Tax rates range from 10%–20%.
The following states impose inheritance taxes:
- New Jersey
If your beneficiary is more than one generation removed:
Generation-skipping taxes may apply to your beneficiary if they are a grandchild or other individual more than one generation removed. For individuals not related to you, an age difference greater than 37 ½ years may trigger a generation-skipping tax.
If there are three parties involved:
Life insurance policies are taxable if the policyholder, insured, and beneficiary are three separate individuals. For example, if you buy a life insurance policy for your spouse but name an adult child as a beneficiary, the death benefit is considered taxable income and your child is responsible for paying taxes on the insurance payout.
If you transfer a life insurance policy to a beneficiary:
If you transfer a life insurance policy while you’re still alive, the beneficiary may owe gift taxes if the total lifetime gift exceeds the estate tax threshold or if the annual gift exceeds $15,000. For more on transferring ownership of a life insurance policy, see “Reducing Taxes With Life Insurance” below.
If you have group life insurance from your employer:
If you’re insured with a group life insurance plan from your employer and they pay your insurance premiums, any death benefit amount over $50,000 may be considered taxable income for your beneficiary.
Cash Value Life Insurance & Taxes
Is interest earned through a cash value life insurance policy taxable?
Interest earned through a cash value life insurance policy is tax-deferred. Depending on how you use your interest, it may or may not be considered taxable income. Keep in mind that interest-earning policies in-force while you’re alive receive preferential tax treatment, but interest-earning policies paid out as annuities to your beneficiary after you pass away are subject to taxation.
Are dividends earned through a life insurance policy taxable?
Dividends earned through a cash value life insurance policy are tax-deferred. Depending on how you use your dividends, they may or may not be considered taxable income.
Are policy loans taxable?
One of the greatest living benefits of cash value life insurance is tax-free policy loans. They allow you to access earned interest and dividends as part of your accumulated cash value and borrow it without paying taxes, for any reason, at any time. Plus, you determine the payback structure of your loan.
Unpaid policy loans will be deducted from your death benefit when you pass away. If your policy lapses while you’re still alive and you have unpaid policy loans, you’ll be responsible for taxes on any amount exceeding your basis—the amount of money you’ve paid into your policy.
Are withdrawals from the cash value of my life insurance policy taxable?
When you make a withdrawal from the cash value of a permanent life insurance policy, any amount exceeding your basis—the amount of money you’ve paid into your policy—is considered taxable income. For this reason, it often is more advantageous to utilize the tax-free policy loan feature of your insurance policy instead of taking a withdrawal.
What happens if I overpay my premiums?
One of the ways to rapidly grow wealth in an insurance policy is with a Paid-Up Additions rider, which allows you to overfund your policy within certain limits. If you exceed these limits, your policy is in danger of becoming a modified endowment contract (MEC) and losing its tax advantaged status.
In a MEC, any withdrawals you make from your cash value are subject to taxation on interest and dividends, regardless of how much you’ve paid in premiums.
To determine the tax status of a cash value life insurance policy, policies are subject to a 7-Pay Test, which places limits on the total amount of premiums that can be paid into a policy within the first 7 years. At Paradigm Life, Wealth Strategists structure whole life insurance policies to meet the 7-Pay Test and retain tax-advantaged status.
Tax Considerations for Terminating, Trading, or Accelerating Insurance Benefits
Are accelerated life insurance benefits taxable?
Some life insurance policies are structured with policy riders—supplemental insurance that allows the policyholder to access additional benefits. One of the most common is a rider that allows the policyholder to access a portion of their death benefit while still living if they are diagnosed with chronic or terminal illness.
In this scenario, the policyholder becomes the beneficiary for a portion of their life insurance payout and the income received isn’t subject to taxes, although it does reduce the death benefit for beneficiaries after the policyholder passes away.
If I trade my life insurance policy for a different policy, is it taxable?
In some cases, you may want to look into transferring cash value from one permanent life insurance product into another, like if you have a universal life insurance policy that is underperforming and you prefer to receive the guaranteed benefits of a whole life insurance policy. In this case, you can utilize a provision of the tax code called a 1035 exchange that allows you to move funds between policies without being taxed for withdrawing your cash value.
If I surrender my insurance policy, is it taxable?
If you decide you no longer need life insurance or can’t afford your policy, you may have the option to surrender your insurance policy back to your insurance company. They payout a lump sum that isn’t considered taxable income, as long as it is less than what you’ve paid into the policy. Essentially, as long as you’re not making a profit surrendering your policy, you don’t have to pay taxes.
If I sell my insurance policy, is it taxable?
Similar to surrendering a life insurance policy, when you sell your policy to an investor or investment company (referred to as a life settlement) you don’t have to pay taxes on the amount of the sale unless it exceeds the amount you’ve paid into the policy. If you have cash value life insurance, you may have to pay income taxes on any amount that exceeds your basis plus additional capital gains taxes on any amount that exceeds the cash value of the policy.
The exception to this rule is if you’re terminally ill. When a terminally ill individual sells their insurance policy to an investment company, it’s called a viatical settlement and the proceeds from the sale are considered by the IRS under code 101(g)(2) to be a payout of the death benefit. In other words, terminally ill individuals who sell their insurance policies don’t have to pay taxes, regardless of the amount of the sale.
Is return of premium life insurance taxable?
Some term life insurance policies are built with a policy rider that allows the policyholder to receive a portion of their insurance premiums back once the policy terminates. Because this amount isn’t greater than the amount paid in insurance premiums, it isn’t considered taxable income.
Tax Considerations for Charitable Contributions
Is a death benefit taxable if it’s donated to charity?
If you decide to name a charitable organization as a life insurance beneficiary, the payout they receive is not considered part of your estate and is exempt from federal estate taxes as long as it qualifies as a charity to the IRS. Charities typically include organizations that are listed as 501(c) and may be churches, museums, art galleries, educational institutions, literary organizations, private foundations, and other public charities.
What are the tax implications if I donate my insurance policy to charity?
Cash value insurance policies (permanent insurance policies) may be donated to charity while you’re still living to help lower your estate taxes, but there’s an added bonus: You may also qualify for income-tax deductions.
If the charity decides to terminate the policy and liquidate the cash value, you may be able to write off the value of the policy as a one-time charitable donation. However, if the charity decides to hold onto the insurance policy and let the cash value grow over time with interest and potential dividends and you continue to pay the premiums, you can also write off each premium payment as a tax deduction.
Reducing Taxes With Life Insurance
How do I transfer a policy to someone else?
One way to reduce estate tax liability with life insurance is to transfer ownership to someone else, typically a family member. In doing so, you lose control of the policy and the new owner is responsible for paying premiums, although you can provide them with funds to pay premiums tax-free as long as the amount doesn’t exceed $15,000 per year (the gift tax threshold).
To transfer ownership of a policy, contact your insurance company. Keep in mind that the new owner must own the policy for at least 3 years for it to no longer be considered part of your estate; should you pass away within 3 years, your policy may be subject to federal and state estate taxes.
How do I use an irrevocable life insurance trust (ILIT) to reduce taxes?
If you’re concerned about estate taxes and their financial implications for your family, naming an irrevocable life insurance trust as the beneficiary on your life insurance policies can shield assets from being included in your estate.
When you pass away, death benefits will be paid to the trust, which has its own tax ID number. The trustee, which may be a family member, lawyer, or other financial professional, is then in charge of distributing the death benefit payout to beneficiaries named in the trust.
If you’re considering this strategy for protecting your wealth, it’s best to purchase insurance policies within the trust. But if you already have insurance policies in place, you can move them into a trust at a later date. The one caveat to this approach is that there is a three-year waiting period between placing insurance policies in a trust and when they are eligible for tax-free status. This means if you pass away before the three-year waiting period is up, assets in your trust may be subject to estate taxes, both federally and on a state level.
How do I enjoy a tax-free retirement?
One of the downfalls of typical qualified retirement plans like a 401(k) is that their tax-deferred status means you have to pay taxes when you take distributions. For individuals who don’t plan on retiring in a lower tax bracket or who don’t like the uncertainty that comes with not knowing what future tax rates will be, whole life insurance provides an alternative for a tax-free retirement.
By structuring a whole life insurance policy with a paid-up additions rider to rapidly grow cash value, retirees can pay for retirement with tax-free policy loans—and you can access this option at any age (401(k)s don’t allow you to take distributions before age 59 ½ without paying a penalty). With this strategy, called a life insurance retirement plan (LIRP), the idea is not to use life insurance for its death benefit and payout to beneficiaries. Instead, the policyholder borrows their cash value to fund retirement and when they pass away, the insurance company deducts the unpaid loans from the death benefit, so the policyholder essentially uses their own death benefit to fund retirement.
Life insurance typically provides loved ones with tax-free income after you pass away and can be used as a living benefit with a variety of tax advantages including tax-free policy loans, tax-free retirement income, and tax-deferred growth for cash value policies.
To learn more about how life insurance can help you avoid excess taxes, and reach out to your tax advisor. Together, we can help you create a comprehensive tax strategy with the right insurance products for your financial goals.