Understanding Taxes on Life Insurance Premiums

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Understanding Taxes on Life Insurance Premiums

Life insurance is a financial instrument that provides financial assistance to the insured’s dependents and heirs in the case of the insured’s death. As long as the policyholder pays the insurance premiums (payments) on the policy, the death benefit coverage continues in force. The premiums owing for a policy are determined by the insured’s age and health (the younger and healthier the insured, the less costly), as well as the amount of the death benefit and whether the coverage is term or permanent. The IRS handles life insurance differently than other forms of financial products since it is designed to assist one’s beneficiaries.

When purchasing life insurance, it is important to examine the tax effects. The Internal Revenue Service (IRS) applies various tax regulations to different plans, and the differences are often arbitrary. The following advice is intended to clarify some of the tax issues associated with life insurance premiums.

Key Takeaways

  • In most cases, life insurance premiums are not taxed (i.e., no sales tax is added or charged).
  • These premiums are not tax deductible either.
  • Any payments for coverage of more than $50,000 made on an employee’s behalf by an employer are taxed as income.
  • Prepaid insurance interest is taxed like interest income.
  • Whole life insurance policy returns are not taxed until the policy is paid out.

Understanding Life Insurance

Before making a choice on life insurance, a person must examine a number of factors. To begin, there is a difference between term and whole life insurance. A term life insurance offers coverage for a specified number of years, while a whole life policy provides coverage for life. A policyholder must also determine how much coverage they need. This is mostly determined by the reason they are purchasing life insurance.

If you are primarily concerned about paying your own burial and funeral expenses for your next of kin, a death benefit of $20,000 or less may be appropriate. In comparison, if you have numerous dependent children, all of whom you want to send to college in the future, you will most likely need coverage of $500,000 or more. The large quantity of life insurance firms from which to pick further complicates the purchasing process. The Internet has made this procedure a little simpler, with some websites solely devoted to comparing quotations from dozens of life insurance firms side by side.

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Unlike purchasing a vehicle or a television, purchasing life insurance does not need the payment of sales tax. This implies that the premium amount you are offered when obtaining coverage is the amount you pay, with no percentage amount added to cover taxes. However, there are several circumstances in which a policyholder is obligated to pay taxes on insurance premiums.

Employer-Paid Life Insurance

When an employer offers life insurance as part of a total compensation package, the IRS considers it income, and the employee must pay taxes on it. These taxes, however, apply only when the employer pays for more than $50,000 in life insurance coverage. Even in such circumstances, the premium for the first $50,000 of coverage is tax-free.

If, for example, an employer provides an employee with $50,000 in life insurance coverage in addition to their salary, health benefits, and retirement savings plan for the duration of their employment, the employee does not have to pay taxes on the life insurance benefit because it does not exceed the IRS threshold.

Alternatively, if the company provides $100,000 in life insurance coverage, the employee must pay taxes on a portion of it. The premium amounts used to pay for the $50,000 in coverage received beyond the IRS threshold are taxable income. As a result, if the monthly premium is $100, the taxable amount is the amount that pays for the extra $50,000 in coverage, or $50.

Prepaid Life Insurance

Some life insurance policies enable the policyholder to pay the premium in one single amount. That money is applied to the plan’s premiums for the length of the plan.

Interest increases the value of the lump-sum payout. The IRS considers the growth of that money to be interest income, which means it may be taxed whether it is applied to a premium payment or when the policyholder withdraws part or all of the money they have earned.

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Life insurance premiums, which the IRS classifies as a personal cost, are not deductible on your federal tax return.

Cash Value Plans

In addition to providing the insured with a predetermined death benefit, many whole life insurance policies accrue cash value when policyholders pay into the plans with their premium dollars. A part of the premium dollars are invested in a fund that earns interest. It is normal for the cash value of a plan to surpass the amount paid in premiums, especially when the plan has been in effect for a long time. People buy this sort of life insurance as an investment instrument as well as to offer security for their relatives in the case of an unexpected death.

Many financial counselors are adamantly opposed to utilizing life insurance as an investment vehicle, stating that the returns have historically been exceedingly low when compared to mutual funds and other investments. Nonetheless, the cash value of most whole life insurance contracts increases with time. Because this is considered income to the policyholder, it is subject to income tax.

The Tax Consequences

The good news for whole life policyholders is that they do not have to pay income taxes on the rise in their plan’s cash value each year. The building of cash value in a whole life insurance policy, like that of 401(k) plans and IRAs, is tax-deferred. Despite the fact that this money is considered income, the IRS does not force policyholders to pay taxes on it until they cash out the insurance.

If a policyholder chooses to take the cash value of their whole life insurance policy, the amount they must pay taxes on is the difference between the cash value they get and the total premiums paid over the policy’s term. If they pay $100 per month for 20 years, or $24,000, and subsequently cash out the insurance for $30,000, the amount due to taxes is $6,000.

Another benefit of whole life insurance is that in many situations, the policyholder may borrow against the cash value of the policy. There is a widespread misperception that the proceeds of this kind of loan are taxed. Even if the loan amount surpasses the entire premiums paid into the insurance, this is not the case.

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Taking out a loan diminishes the policy’s death benefit value until it is returned (along with any interest owed).

When Are Life Insurance Premiums Tax-Deductible?

Premiums for life insurance are not normally tax deductible. However, if you are a company owner who has acquired life insurance coverage for key workers or as part of a buy-sell arrangement, you may be eligible to deduct them as a business expenditure. Also, if you divorced before 2019 and have a court-ordered life insurance policy, your payments may be deductible.

Are Life Insurance Death Benefits Taxed?

The death benefit from life insurance is tax-free for the recipients. However, if the whole value of the estate, including the death benefit, exceeds the tax threshold, it may be liable to estate tax.

Are Withdrawals from Permanent Life Insurance Taxed?

Certain tax benefits apply to cash-value life insurance. One of them is that withdrawals from the insurance are deemed a refund of previously paid premiums and are so exempt from taxes. However, if you take the whole amount of your premiums and begin pulling earnings from interest or dividends, those dollars will be taxed as income.

The Bottom Line

Life insurance premiums are not normally subject to sales tax and are not tax deductible in most cases. However, there are several scenarios in which the IRS may interpret life insurance premiums differently and you will suffer tax implications. These situations often emerge when a company owns or pays for a life insurance policy.

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