Are Life Insurance Premiums Tax Deductible?
A PolicyScout Breakdown on the Tax Implications of Life Insurance Premiums.
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According to the Internal Revenue Service (IRS), life insurance premiums for individuals are personal expenses and therefore not classified as tax-deductible.
However, about half of Americans believe their insurance premiums are tax-deductible, which is a misconception.
In this article, we will discuss the definitions of tax deduction and life insurance premiums, and also how these terms relate to each other.
Source: Pexels
What Is Life Insurance?
Life insurance is a type of long-term coverage that insures a person’s life. Life insurance policies are contracts between policyholders and insurance companies.
A policyholder (the person covered by the life insurance policy) pays a monthly or annual premium to the life insurance company (the business offering coverage).
In exchange, the life insurance company promises to pay out a death benefit to the insured person’s beneficiaries when they die.
Terms You Should Know:
Death Benefit: The amount of money that will be paid out to a policyholder’s beneficiaries when they die.
Premium: A regular payment made to an insurance company in exchange for insurance coverage.
Policyholder: The person who is insured by a life insurance contract.
Beneficiary: A nominated person who will receive the full or a portion of a life insurance contract’s death benefit.
What Is a Tax Deduction?
A tax deduction is an expense you can subtract from your taxable income. This lowers the amount of money you pay taxes on and reduces your tax bill.
Tax deductions may be grouped into three categories:
Itemized deductions are expenses allowed by the IRS that can decrease your taxable income. Numerous expenses can be classified as itemized deductions, for example, medical expenses.
The standard deduction is the itemized deduction's counterpart. This is a flat-rate, no-questions-asked reduction in your adjusted gross income (AGI).
Above-the-line deductions, officially known as “adjustments to income,” are deductions that are subtracted from your gross income before calculating your AGI (e.g. alimony).
Are Life Insurance Policies Tax-Deductible?
In most cases, you can't write off the money you pay for life insurance on your taxes. This is because the IRS sees your insurance premiums as personal expenses, such as food or clothing.
The government doesn't require you to get life insurance in your state or country, so you can't expect to get a tax break after you buy it.
However, if you die while the policy is still in effect, your loved ones get a tax-free cash payment that they can use to replace your income, pay bills or debts, save for the future, or buy anything else they want.
When Is Life Insurance Tax-Deductible?
There are a few exceptions to the general rule that you can't deduct premiums. You may be able to write off some or all of the money you pay for life insurance if you:
Have a business that offers benefits.
Have an older alimony agreement (before 2019).
Give a policy as a charitable gift.
Employers Offering Life Insurance as an Employee Benefit
Owners of limited liability companies (LLCs) and S corporations can deduct premium payments they make on behalf of employees.
What Are LLCs and S Corporations?
LLCs are businesses in the U.S. where owners are not responsible for their debts or liabilities.
LLCs have the same characteristics of corporations, partnerships, or sole proprietorships.
S corporations are business entities that pass their profits, losses, deductions, and credits to their shareholders for federal tax purposes.
The company must provide life insurance as an employee benefit. Neither the business owner nor the company is allowed to be the policy’s beneficiary.
The benefit may also be ruled out for a deduction if:
You are self-employed or run a sole proprietorship. Even though the company can write off other expenses — such as health insurance — life insurance isn't one of them. If you pay for your policy, you can't write it off.
The company offers more than $50,000 in coverage. The IRS doesn't let you write off the premiums you pay for insurance exceeding this amount. This is because the IRS sees them as wages, which you can’t deduct from taxes.
Your spouse works for your company. In this case, their policy pays out to you, so you — the business owner — would get money and therefore not be able to take a deduction because of it.
People with Alimony Agreements from before 2019
Life insurance that is linked to divorce is usually not tax-deductible. There is, however, an exception if you have an alimony agreement that:
States you have to pay for your ex-spouse's life insurance.
Came into effect before 2019.
However, if your alimony agreement says you have to name your ex-spouse as the beneficiary of your policy, those premiums are not deductible.
Because of recent tax code changes, any alimony agreements after 2019 are not eligible for a tax deduction.
Give a Policy as a Gift
An existing life insurance policy gifted to a charity may be tax-deductible.
As long as the donor lists all of their deductions and makes the charity the owner and beneficiary of the policy, this should work.
The donor can get a tax deduction on the policy that is worth less than the fair market value of the policy.
If the policy is subject to a loan, the deduction will be less.
Source: Unsplash
Do Beneficiaries Pay Taxes on Life Insurance?
Usually, when the beneficiary of a life insurance policy gets a death benefit, they don't have to pay taxes on it.
However, there are scenarios where the beneficiary of a policy is taxed on some or all of the policy's money.
If the policyholder doesn't want the money to be paid out immediately when they die, they can choose to have the money held by the life insurance company for a certain period.
In this case, the beneficiary may have to pay taxes on the interest generated during that time.
If the policyholder named an estate as the beneficiary, the person(s) who inherit the estate may have to pay estate taxes.
However, it's possible to avoid these taxes in several ways, such as:
Creating an irrevocable life insurance trust (ILIT).
What Is an Irrevocable Life Insurance Trust (ILIT)?
An ILIT is a trust that can't be changed, canceled, or amended after it's been set up. They are made with a life insurance policy as the main asset in the trust.
Once the grantor gives property or life insurance death benefits to the trust, they can't change the terms of the trust or get back any of the money or property that the trust holds.
An ILIT can be used:
To minimize estate taxes
To avoid gift taxes
To protect government benefits
To protect assets
For distribution control
For legacy planning
For various tax considerations
How Much Tax Do You Pay on a Permanent Life Insurance Policy?
The good news for a whole life insurance policyholder is that they don't have to pay income taxes each year on the growth in their plan's cash value.
A policyholder of a whole life insurance policy doesn't have to pay income taxes each year on the growth of their plan's cash value.
It works like retirement accounts, such as a 401(k) plan or an individual retirement account (IRA). The cash value in a whole life insurance policy grows on a tax-deferred basis.
What Is the Difference Between a 401(k) Plan and an IRA?
A 401(k) plan is a retirement savings plan offered by many U.S. employers that offers tax advantages to the saver.
An IRA is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth or on a tax-deferred basis.
The IRS rules state that even though this money is income, the policyholder doesn't have to pay taxes on it until they cash out the policy.
People who have whole life insurance can take out the cash value at any time.
However, when they do take it out they have to pay taxes on the difference between what they get and what they paid in premiums while the policy was in effect.
For example, if they pay $200 per month for 25 years, or $60,000, and then cash out the policy and receive $70,000, the amount subject to taxes is $10,000.
Some people are eligible for a loan from the cash value of their whole life insurance plan.
However, there is a misconception that the money from this kind of loan is taxed. This is not true, even if you borrow more than you paid in premiums.
When you take out a loan, the cash value of the policy is reduced. If applicable, the death benefit that is paid will also be less.
Tax Implications for Term and Whole Life Insurance
There are two main types of life insurance policies: term and whole life insurance.
| Term | Whole Life |
|---|---|
| Term life plan only offers coverage for a fixed period of time. | Whole life insurance offers coverage for your whole life. |
| The coverage will only last as long as the set number of years agreed upon in the contract. | The coverage never expires as long as you keep making your premium payments. |
| There is no “cash value.” | It provides some “cash value” in addition to the death benefit. |
| You can increase the death benefit. | You can’t increase the death benefit. |
| The death benefit is generally paid out income tax-free. | The death benefit is generally paid out income tax-free. |
| Because there is no cash value, it does not accumulate on a tax-deferred basis. | The cash value does accumulate on a tax-deferred basis. |
| Because there is no cash value, you can’t access it on a tax-advantaged basis. | You can access the cash value of the policy on a tax-advantaged basis. |
What Is Cash Value?
There are benefits that a policyholder can use while they are alive, called living benefits. The most common example is a cash-value account.
A cash value account is a type of savings account that policyholders with permanent life insurance can use to build up additional wealth through their policy.
Source: Unsplash
Where Can I Learn More about Life Insurance?
Tax deductions can help you shave hundreds, even thousands of dollars off your tax bill. Visit our Life Insurance Hub if you’d like to find out more about your coverage options, benefits, and costs.
If you’re currently looking for where you can save on tax through your life insurance, get in touch with one of our professional consultants for tailored advice. Send us an email at help@policyscout.com or give us a call at 1-888-912-2132.