Understanding Taxes on Life Insurance Premiums

Understanding Taxes on Life Insurance Premiums

Find out when you might owe Uncle Sam money

When you buy life insurance, it’s important to consider the tax implications. The Internal Revenue Service (IRS) imposes different tax rules on different plans, and sometimes this distinction is arbitrary. The following guide is intended to help explain some of the tax issues related to life insurance premiums.

KEY TAKEAWAYS

  • In most cases, life insurance premiums are not taxable (ie, no sales tax is added or charged). These premiums are also not tax-deductible;
  • If an employer pays life insurance premiums on behalf of an employee, premiums over $50,000 will be taxed as income.
  • Interest income from prepaid insurance is taxed as interest income;
  • Income from a whole life insurance policy is not taxed until the policy is cashed;

primary consideration

People who buy life insurance have many things to consider before making a decision. First of all, there is a difference between term life insurance and whole life insurance. Term insurance provides coverage for a certain number of years while whole life insurance is valid for a lifetime. 1 Policyholder must also calculate how much coverage they need. A lot depends on why they are buying life insurance.

If you only care about paying for your funeral and funeral expenses for your next of kin, you can opt for a death benefit of $20,000 or less. By contrast, if you have several dependent children who you hope will all go to college in the future, you may want coverage for $500,000 or more. Further complicating the buying process is the sheer number of life insurance companies to choose from. The internet has made this process easier, and there are several websites dedicated to comparing quotes from dozens of life insurance companies.

life insurance premium tax

Unlike buying a car or a TV, buying life insurance is not subject to sales tax. This means that the premium amount quoted when you, as the policyholder, obtain coverage is the amount you paid, without adding any percentage amount to pay taxes. That said, in some cases, policyholders are required to pay tax on premiums.

Employer Paid Life Insurance

When an employer offers life insurance as part of an overall compensation package, the IRS treats it as income, which means the employee is taxed. However, these taxes only apply to life insurance where the employer pays more than $50,000. Even in this case, the first $50,000 in insurance premiums are tax-deductible. 2 

For example, if an employer provides an employee with $50,000 in life insurance while they are employed, along with a salary, health benefit, and benefit retirement savings plan, the employee does not have to pay tax on the life insurance benefit because it does not exceed the threshold set by the IRS.

Or, if the employer-provided life insurance is $100,000, the employee must pay part of the tax. Premiums paid more than the IRS threshold of $50,000 are included in taxable income. So, if the monthly premium amount is $100, the taxable amount is the amount paid for the additional $50,000 in coverage, which is $50.

prepaid life insurance

Some life insurance plans allow policyholders to pay a premium upfront. The money will be used for insurance premiums throughout the plan. The lump-sum payment is also appreciated by interest. The growth of this money is considered interest income by the IRS, which means it may be taxable when it is used to pay premiums or when the policyholder withdraws some or all of their income.  

Life insurance premiums that the IRS class as personal expenses cannot be deducted on your federal tax return.

Cash value plan

Many whole life insurance plans, in addition to providing the insured with a fixed death benefit, also accumulate cash value when policyholders use their premiums to invest in the insurance plan. A portion of the premium dollar goes into a fund that accumulates interest. It is common for the cash value to exceed the amount the policyholder pays the premium, especially in insurance plans that have been in place for many years. People use this type of life insurance as an investment vehicle while taking advantage of the protection it provides their family members in the event of an untimely death. 

Many financial advisors remain staunchly against using life insurance for investment purposes, claiming that historically, life insurance has had extremely low returns compared to mutual funds and other investments. Still, the fact remains that the cash value of most whole life insurance policies grows over time. Because this is considered the policyholder’s income, income tax is involved.

tax consequences

The good news for whole life policyholders is that they don’t have to pay income tax every year on the increase in the plan’s cash value. Similar to retirement accounts, such as 401(k) plans and the Republic of Iran, in a life insurance policy, the accumulation of cash value is tax-deferred. Even if the money qualifies as income, the IRS doesn’t require policyholders to pay taxes on it before cashing out the policy.

If policyholders choose to purchase the cash value of their whole life insurance policy, the tax they will pay is the difference between the cash value they receive and the total premiums they paid while the policy was in effect. 5 For example, if they paid $100 a month for 20 years, or $24,000, and then cashed out the policy and received $30,000, the tax liability would be $6,000.

Another feature of life insurance is that, in many cases, the policyholder can take out a loan based on the cash value of the policy. There is a misconception that the proceeds of such loans are taxable. But this is not the case, even if the loan amount exceeds the total premium paid to the policy. 6 The loan will only reduce the cash value of the policy and, if applicable, death benefit payments.

By aamritri

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