Is Life Insurance Tax Deductible? Understanding How Life Insurance Impacts Taxes

Well, that’s the good news about life insurance. It turns out that life insurance provides favorable tax treatment in its own way: death benefits are typically not subject to income tax when your loved ones are the financial beneficiaries and receive the money. Each life insurance situation is different, and we encourage you to speak to your tax professionals.

Not only is that a huge financial relief, but it means that during a time of loss and grief, your family or loved ones won’t have to worry about paying taxes on the cash money they receive–because the payout is not regarded as income. (In certain circumstances, some states might impose taxes on life insurance benefits, so it’s worth having a conversation with a tax professional.) Having this financial cushion offers peace of mind, and possibly long-term financial security, for the people you love.

If you die while the life insurance policy is active, your beneficiary will receive a lump sum that they can apply toward retirement, debt, or just saving for the future. It’s up to them—no strings attached. So if your loved ones ever ask, “Do we pay taxes on life insurance?” you can reassure them that the answer is likely ‘no.’

While, in most cases, your life insurance premiums are not taxable, sometimes, the death benefit can be. For example, if your beneficiaries decide to receive the death benefit in installments rather than in one lump sum, there's a chance it could be taxed as income.

There are two other situations in which the death benefit might be taxed on a life policy. For example, your insurance beneficiaries may have to pay applicable estate taxes for life insurance proceeds if they exceed their remaining lifetime exclusion at the time of the policyholder's death.

The final scenario when the death benefit is taxable applies to the transfer-for-value rule. There are insurance companies that can allow you to sell your insurance policy to someone else in exchange for something of value. While this is a rarer scenario, your insurance death benefit could be taxed as income so long as it does not fall under an exception.

As always, speak with your tax guidance advisors regarding whether or not the death benefit is taxable income in your specific situation.

Every life insurance situation is different, and the IRS accounts for that. While it's natural to want to increase your cash savings, most people can’t get a tax deduction for these payments. Of course, there are certain exceptions:

1) You own a small business and offer life insurance as a benefit to your employees.  

Some businesses are able to deduct the premiums they pay for their staff. If your business qualifies, you can only deduct premiums for up to $50,000 of coverage. Keep in mind that the business policy's total benefit cannot exceed this $50,000 in coverage. Any amount over that threshold must be included in income and may be subject to Social Security and Medicare taxes.

Note: you can’t deduct these payments if you (or your business) is the beneficiary of a group policy. Similarly, this won’t work if your spouse works for your business, because you’d potentially benefit from the insurance payout.

2) You give the insurance policy as a charitable gift. 

Transferring ownership of an insurance policy can be a savvy tax move. By giving your life insurance policy to, say, a favorite non-profit organization, or naming a charity as your beneficiary, you can give yourself a nice advantage at tax time. Because the life insurance policy is a charitable gift, the premiums you pay–or the cash value of the policy (whichever amount is less)–are indeed considered tax-deductible.

Note: How the premiums are paid can impact whether or not they qualify as tax-deductible. The amount that is deductible after gifting the insurance policy to charity can change if you pay your premium directly to your insurer rather than to the charity itself.

3) You bought an insurance policy for a former spouse. 

If you pay for the life insurance premiums for an ex-spouse or partner, the premiums you pay may be tax deductible. This is because these premiums can be considered alimony when your former spouse is the policy holder (not the beneficiary)!

However, not all divorces count–but if you have an alimony agreement that took effect prior to 2019, you should be able to take the deduction. Alimony agreements after 2019 don’t count because of some recent tax code changes.

Is the cash value of universal life taxable? The cash investment portion of your universal life insurance grows tax-deferred (just as a traditional IRA does). This means that when the money is withdrawn, you’ll only owe taxes on the earned interest.

To get more specific: ‘tax-deferred’ means the accumulation of investment earnings (interest, dividends, and so on) that you don’t have to pay taxes on until you withdraw the money. 

However, it's important to note that many insurance companies can allow you to take loans against your policy. Generally speaking, these insurance loans are tax-free.

In most cases, you can borrow against your policy penalty-free and free of federal income tax. You can typically use these loans for your business or other business costs, to pay off credit cards, offer a down payment on a mortgage, or pay off student expenses.

Keep in mind that if your insurance policy lapses or you surrender your insurance policy with an outstanding loan, some portion of the cash value accessed may be taxable. Always seek the advice and counsel of a seasoned tax professional regarding taxes and your life insurance policy.

• Financial Dependency: Consider who relies on your income for financial support, such as spouses, children, or elderly parents.
  
• Familial Relationships: Take into account your relationship with potential beneficiaries and their financial needs.
  
• Estate Planning Goals: Determine how life insurance fits into your overall estate planning strategy and how you’d like the death benefit will be distributed among beneficiaries.
  
• Regular Review and Updates: It's essential to review and update your beneficiary designations regularly, especially after major life events such as marriage, divorce, or the birth of children.
  
  

So in certain cases you can deduct your life insurance payments from taxes, but in most cases, you can’t.   

Obviously, life insurance is a major investment, and a deeply personal matter. Regardless of your personal situation, it’s important to discuss any potential implications with a tax professional to correctly determine your deduction eligibility. Be sure to write down your tax and insurance questions ahead of time, so you’ll be fully prepared and ready for tax-deferred interest! Then give yourself a pat on the back for thinking ahead and taking such good care of the people you love, even after you’re gone.