Life insurance provides a financial cushion to your loved ones when you pass away. But what happens when a policy is paid out? Is the money taxable? Are premiums taxable? Let's go over the answers to the most common life insurance tax questions.
Answers To Common Tax Questions On Life Insurance
There are many different types of life insurance policies designed for varying individual needs. Life insurance policies can be straight forward like term life insurance, or quite complex like indexed universal life insurance.
Once you have a good grasp of the different types of life insurance, you may have some questions about taxes. Let's go over the most common list insurance tax questions answered.
Are Life Insurance Death Benefit Payouts Taxable?
Life insurance death benefit payouts are typically tax-exempt. In other words, beneficiaries can get a lump sum of cash completely tax-free after filing a claim for the policyholder's death.
The IRS does not require beneficiaries who receive a death benefit to report that money anywhere on their tax returns. It's not considered gross income.
Although life insurance death benefit payouts are not taxable, there can be certain situations when taxes may occur:
- If a beneficiary elects to delay receiving a death benefit payout versus receiving payment immediately, he or she may owe taxes on any earned interest income during that period of time.
- If a death benefit is paid directly to the policyholder's estate, the person(s) who inherit the estate could be subject to estate taxes.
Are Life Insurance Premiums Taxable?
Life insurance policies are not subject to sales tax. Thus, if you are comparing life insurance policies, the premiums you are quoted are what you'll actually pay – there are no taxes added on top.
If you ever see taxes added to your life insurance premiums, talk to your insurance provider and ask for clarification. There may be some rare situations when taxes are required, but it's unlikely.
Are Life Insurance Premiums Tax-Deductible?
A common misconception is that life insurance premiums are tax-deductible. It sure would be nice if we could get a tax break for having a life insurance policy.
Unfortunately, the IRS considers life insurance premiums to be personal expenses. Thus, money spent on personal expenses is not tax-deductible when you file your tax return.
Is Prepaid Life Insurance Subject To Taxes?
Most life insurance policies, such as a typical term life insurance policy, require the policyholder to pay monthly premiums for the entire duration of the policy to remain active.
Prepaid life insurance is structured differently: the policyholder pays a lump sum premium upfront. That money is then applied to the plan's premium over time.
Interest is then earned on the lump sum. Interest income is typically subject to taxes by the IRS and should be reported on your tax return when it's applied to a premium payment or withdrawn.
Are Employer-Paid Life Insurance Benefits Taxable?
Some employers provide life insurance benefits to their workers. My wife and I were both fortunate to have employer-paid life insurance while we were working at traditional day jobs.
After we negotiated severances and left our jobs, we made sure we had enough private life insurance to meet our needs.
If your employer's benefits package includes life insurance as part of your compensation, it is considered income. Taxes apply to this “income” if your employer pays for $50,001 or more in life insurance coverage. The first $50,000 is tax-free.
As an example, let's say you have $100,000 in life insurance coverage with a $100 premium. The first $50 of the premium for $50,000 in coverage is tax-free. The second $50 of the premium for the remaining $50,000 in coverage is taxable.
Are Taxes Due Each Year On Cash Value Life Insurance Plans?
Certain types of life insurance policies, such as whole life insurance, build cash value over time in addition to a fixed death benefit amount. A portion of the premiums goes into a fund that earns interest.
Over time, the cash value can exceed the amount the policyholder has paid in premiums. The growth on the cash value is considered taxable income by the IRS.
Fortunately, taxes are not due each year as the cash value grows. The earnings are tax-deferred. That means, the policyholder doesn't owe taxes on it until the policy is cashed out.
The amount of taxes due is calculated by taking the difference between the cash value received and the total paid in premiums. So if you pay $24,000 over 20 years ($100/month) and receive $30,000 when you cash out, you'd only owe taxes on $6,000.
If You Take Out A Loan On Your Life Insurance Policy, Is It Taxable?
Whole life insurance policies build cash value over time. Policyholders can choose to take out a loan against that cash value. You might think that results in a taxable event, especially if the loan amount is greater than what has been paid into the policy.
Taking out a loan on your life insurance policy isn't taxable, however. It's just decreasing the policy's cash value, and also the death benefit amount if applicable.
Life insurance comes in many different forms and is a great way to provide financial protection to your loved ones and assets.
Although it may seem like a daunting task to get a life insurance, it really isn't. Once you understand the different types of life insurance, it's helpful to understand if and when taxes apply. Here's a quick recap of the most common list insurance tax questions answered.
- Life insurance death benefit payouts are typically tax-exempt.
- There's no sales tax on life insurance policies.
- Unfortunately, life insurance premiums are not tax-deductible.
- Interest income earned on prepaid life insurance policies is taxable income.
- The first $50,000 in employer-paid life insurance coverage is tax-free for employees. Then, employees have to pay taxes on the pro-rated portion of premiums for coverage over $50k.
- Policyholders don't have to pay annual taxes on cash value life insurance plans. Taxes are deferred, i.e. due when you cash out.
- Loans taken out against life insurance policies are not taxable.
Get Free Life Insurance Quotes
There are a lot of different options when it comes to purchasing a life insurance policy. Life insurance can provide critical financial relief and help you and your family sleep easier at night.
Thanks to technology, it’s easier than ever to compare term life insurance policies. The most efficient and free way to get competitive life insurance quotes is to check online with PolicyGenius. They are the #1 life insurance marketplace where qualified lenders compete for your business.
You can quickly search for policies across multiple carriers through PolicyGenius’s online portal for free. I’ve know the founders of PolicyGenius for years and they have truly build a fantastic resource for individuals.
About the Author: Sam worked in investment banking at Goldman Sachs and Credit Suisse for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley.
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $265,000 a year in passive income. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too. He started Financial Samurai in 2009 and has grown it to be one of the largest independently owned personal finance sites in the world with over 1 million organic visitors a month.