When shopping for coverage, understanding how life insurance works and the types of policies available are important. Unfortunately, what are often overlooked are the tax laws and implications of your policy. While all life insurance provides financial security for dependents and beneficiaries in the event of a death, some also offer tax advantages. Knowing which types of life insurance and structures save money on taxes can help consumers make informed decisions when buying a life insurance policy and setting up a trust. Read further to learn more about how life insurance is taxed.
Premiums and Deductions
Question: Are life insurance premiums tax deductible for personal returns? No. Premiums for personal life insurance policies are not tax deductible. However, premium payments may be deductible and expensed if they are part of alimony payments or as charitable contributions. Consult your accountant to confirm you qualify for this tax break.
Payouts and Trusts
Question: Is the death benefit payout taxable if dispersed to a trust? No, proceeds are generally tax exempt income to the trust, trustee and the beneficiaries, when distributed. However, when retained by the trust, gains or investment income on the proceeds are taxed in the same way as other trust income.
To expand on this last point, the exception is when beneficiaries decide to have the death benefit paid in installments instead of a lump-sum. While the principal portion of installment payments is tax-free, any interest earned is taxable as income at normal rates.
Question: Is life insurance tax deductible? It depends what component of the policy you mean by “life insurance”. As discussed above, premiums are not tax deductible. On the other hand, death benefits are generally paid out tax-free, meaning that the IRS does not see a payout as taxable income and beneficiaries will receive the entire death benefit amount.
Depending on the coverage amount of the policy, you can avoid estate taxes on the death benefit by transferring ownership of the policy to your beneficiaries or a trust more than 3 years before your death. Please consult a tax advisor to learn more about exceptions in your state (or the state where the policyholder lived).
Cash Value – Loans and Gains
Question: For my current federal income tax filings, are the gains or returns on my cash value taxable? As your cash value grows, it is not subject to income or capital gains taxes. Income taxes on earned interest are deferred until the cash value is withdrawn from the policy. When you do withdraw from or surrender the policy, the difference between paid-in premiums and your distribution is taxed.
Question: If I borrow from my policy’s cash value or take out a loan using the cash value as collateral, will I pay income taxes on the withdrawal? No, as a general rule, loans do not count as taxable distributions, if the withdrawal is structured properly. This can give retired couples access to tax-free cash to supplement their current income.
Furthermore, the interest paid on cash value loans is not tax deductible. The exceptions to this rule are special kinds of loans from business-owned policies.
Question: Do I need to pay taxes on dividends from participating whole life insurance? In most cases, the answer is no. Life insurance dividends are considered a “return of premiums”. As long as the received dividend payout is less than your annual premiums, the dividend is not taxable. However, if the dividend distribution is greater, the difference is taxable. Additionally, if your dividends earn interest while left on deposit with your insurance company, the interest earned is taxable income.
Irrevocable Life Insurance Trust
While the death benefit on insurance policies is not subject to income taxes, it may be subject to estate taxes, which in the United States range from 35% to 45%. In an irrevocable life insurance trust, the insured transfers ownership of a life insurance policy to a trust, which can act as a tax shelter for beneficiaries if the insured dies. The life insurance trust is exempt from estate taxes since it is not considered part of the deceased’s estate. The trust must be administered by a trustee, someone other than the insured, who has no interest in the trust.
Survivorship Life Insurance
Survivorship life insurance covers two people, who are usually married, under one policy. Survivorship life insurance may be a first-to-die policy, which pays benefits to the survivor, or a second-to-die policy, which pays benefits only after the second insured policyholder dies. Survivorship policies can offer substantial tax benefits for those with large estates, but the tax laws are complicated when setting up estates, so consult a professional who specializes in estate planning before deciding to purchase a survivorship policy.
Taxes on Life Insurance
When life insurance is used as a tool in estate planning, it is best to consult an attorney to determine which types of insurance offers the greatest tax advantages for your specific situation. Tax laws are complex, and only an attorney who specializes in tax law or estate planning can determine how best to utilize life insurance when establishing a trust or legacy for heirs.