Tax on Life Insurance Payout? Is Life Insurance Tax Deductible?
Know the Rules When Filing This Tax Season
Life insurance is a personal financial tool primarily designed to benefit your survivors in the event of your untimely death, or depending on the type policy, work as an investment tool. But many policyholders wonder if there is a tax on life insurance payouts and often ask, “Are life insurance premiums tax deductible?
The IRS has many rules and regulations on life insurance policies, mostly to prevent unintended parties from profiting on life insurance. And because life insurance is a personal investment, your premiums are not tax deductible in the vast majority of cases. It doesn’t matter who pays for the premium—a spouse, family member, or friend—or what kind of policy you have—from a private provider or from a government program. The only exceptions are premiums paid as part of an alimony settlement or as a charitable contribution.
The simplest case is for a term life policy with no savings element, paid for, and owned, by yourself with beneficiaries named. There are no tax deductions for the premiums that are paid on the life insurance policy, and if the policy is paid out to beneficiaries they receive their designated portion of the face value with no tax cost to them. This ensures that the beneficiaries you choose receive the full benefit of the protection life insurance provides.
Some people receive life insurance as part of an employer benefits package. These employer-paid policies have special rules. As long as your employer is not the direct beneficiary of the policy, you have to declare such premium payments as taxable income, with some exceptions. A policy with a face value, or the amount paid out on death, that does not exceed $50,000 is counted as a non-taxable fringe benefit. If the employer provided policy exceeds a $50,000 face value, the portion of the premium going towards the face value over $50,000 must be declared on your tax return.
Whether you have to pay taxes on employee contributions to employer-paid life insurance premium costs depends on what kind of policy you have and whether your premiums are paid with before-tax or after-tax dollars. Most individual employee contributions are paid with after-tax dollars and not counted up to the $50,000 threshold. Life insurance offered through qualified retirement plans are covered with pre-tax dollars. Pre-tax contributions are generally lower, but you have to pay a tax on the difference between the cash value of the policy and the total death benefit, known as the pure life insurance value of the policy.
Other kinds of life insurance policies have special tax rules as well. Participating permanent life insurance policies, policies that involve a “with-profits” element, payout dividends typically based on the profits of your life insurance company. Dividends can be used to reduce the premium costs, taken as cash or added to the savings element of the policy. As long as the dividends do not exceed the premiums paid they are not taxable.
Life insurance policies with a savings element, such as whole life insurance, are typically tax deferred. Any interest that is built up in the savings element of the life insurance is not taxed annually, instead it builds up untaxed in the policy. When a claim is made on the cash value of the policy, for example if the policy is surrendered for cash value before it reaches maturity, you would only be taxed on the cash value that exceeds premiums that you have paid.
These tax rules can affect you differently depending on the kind of life insurance policy you own. They are a small price to pay to protect your family, who do not pay a tax on life insurance payouts. When a claim is made on a life insurance policy by a beneficiary, the face value of the policy is not taxed, so your beneficiaries will receive the full, guaranteed value of the life insurance policy tax free.
This protection against any tax on life insurance payouts is designed to protect your loved ones from unforeseen financial hardship and ensures that they receive the full benefit of your investment.
To fully understand your particular tax situation seek advice from a tax professional.