|Tax Planning Tips: Life Insurance
Understanding the importance of life insurance is one thing.
Understanding the tax rules is quite another. As insurance products have
evolved and become more sophisticated, the line separating insurance vehicles
from investment vehicles has grown blurry. To differentiate between the two, a
mix of complex rules and exceptions now governs the taxation of insurance
products. If you have neither the time nor the inclination to decipher the IRS
regulations, here are some life insurance tax tips and background information
to help you make sense of it all.
Life insurance contracts must meet IRS requirements
For federal income tax purposes, an insurance contract
cannot be considered a life insurance contract--and qualify for favorable tax
treatment--unless it meets state law requirements and satisfies the IRS's
statutory definitions of what is or is not a life insurance policy. The IRS
considers the type of policy, date of issue, amount of the death benefit, and
premiums paid. The IRS definitions are essentially tests to ensure that an
insurance policy isn't really an investment vehicle. The insurance company must
comply with these rules and enforce the provisions.
Keep in mind that you can't deduct your premiums on
your federal income tax return
Because life insurance is considered a personal expense, you
can't deduct the premiums you pay for life insurance coverage.
Employer-paid life insurance may have a tax cost
The premium cost for the first $50,000 of life insurance
coverage provided under an employer-provided group term life insurance plan
does not have to be reported as income and is not taxed to you. However,
amounts in excess of $50,000 paid for by your employer will trigger a taxable
income for the "economic value" of the coverage provided to you.
You should determine whether your premiums were paid
with pre- or after-tax dollars
The taxation of life insurance proceeds depends on several
factors, including whether you paid your insurance premiums with pre- or
after-tax dollars. If you buy a life insurance policy on your own or through
your employer, your premiums are probably paid with after-tax dollars.
Different rules may apply if your company offers the option
to purchase life insurance through a qualified retirement plan and you make
pretax contributions. Although pretax contributions offer certain income tax
advantages, one tradeoff is that you'll be required to pay a small tax on the
economic value of the "pure life insurance" in the policy (i.e., the difference
between the cash value and the death benefit) each year. Also, at death, the
amount of the policy cash value that is paid as part of the death benefit is
taxable income. These days, however, not many companies offer their employees
the option to purchase life insurance through their qualified retirement plan.
Your life insurance beneficiary probably won't have to
pay income tax on death benefit received
Whoever receives the death benefit from your insurance
policy usually does not have to pay federal or state income tax on those
proceeds. So, if you die owning a life insurance policy with a $500,000 death
benefit, your beneficiary under the policy will generally not have to pay
income tax on the receipt of the $500,000. This is generally true regardless of
whether you paid all of the premiums yourself, or whether your employer
subsidized part or all of the premiums under a group term insurance plan.
Different income tax rules may apply if the death benefit is
paid in installments instead of as a lump sum. The interest portion (if any) of
each installment is generally treated as taxable to the beneficiary at ordinary
income rates, while the principal portion is tax free.
In some cases, insurance proceeds may be included in
your taxable estate
If you hold any incidents of ownership in an insurance
policy at the time of your death, the proceeds from that insurance policy will
be included in your taxable estate. Incidents of ownership include the right to
change the beneficiary, the right to take out policy loans, and the right to
surrender the policy for cash. Furthermore, if you gift away an insurance
policy within three years of your death, then the proceeds from that policy
will be pulled back into your taxable estate. To avoid having the policy
included in your taxable estate, someone other than you (e.g., a beneficiary or
a trust) should be the owner.
Note: If the owner, the insured, and the beneficiary are
three different people, the payment of death benefit proceeds from a life
insurance policy to the beneficiary may result in an unintended taxable gift
from the owner to the beneficiary.
If your policy has a cash value component, that part
will accumulate tax deferred
Unlike term life insurance policies, some life insurance
policies (e.g., permanent life) have a cash value component. As the cash value
grows, you may ultimately have more money in cash value than you paid in
premiums. Generally, you are allowed to defer income taxes on those gains as
long as you don't sell, withdraw from, or surrender the policy. If you do sell,
surrender, or withdraw from the policy, the difference between what you get
back and what you paid in is taxed as ordinary income.
You usually aren't taxed on dividends paid
Some policies, known as participating policies, pay
dividends. An insurance dividend is the amount of your premium that is paid
back to you if your insurance company achieves lower mortality and expense
costs than it expected. Dividends are paid out of the insurer's surplus
earnings for the year. Regardless of whether you take them in cash, keep them
on deposit with the insurer, or buy additional life insurance within the
policy, they are considered a return of premiums. As long as you don't get back
more than you paid in, you are merely recouping your costs, and no tax is due.
However, if you leave these dividends on deposit with your insurance company
and they earn interest, the interest you receive should be included as taxable
Watch out for cash withdrawals in excess of
If you withdraw cash from a cash value life insurance
policy, the amount of withdrawals up to your basis in the policy will be tax
free. Generally, your basis is the amount of premiums you have paid into the
policy less any dividends or withdrawals you have previously taken. Any
withdrawals in excess of your basis (gain) will be taxed as ordinary income.
However, if the policy is classified as a modified endowment contract (MEC) (a
situation that occurs when you put in more premiums than the threshold allows),
then the gain must be withdrawn first and taxed.
Keep in mind that if you withdraw part of your cash value,
the death benefit available to your survivors will be reduced.
You probably won't have to pay taxes on loans taken
against your policy
If you take out a loan against the cash value of your
insurance policy, the amount of the loan is not taxable (except in the case of
an MEC). This result is the case even if the loan is larger than the amount of
the premiums you have paid in. Such a loan is not taxed as long as the policy
is in force.
If you take out a loan against your policy, the death
benefit and cash value of the policy will be reduced.
You can't deduct interest you've paid on policy loans
The interest you pay on any loans taken out against the cash
value of your life insurance is not tax deductible. Certain loans on
business-owned policies are an exception to this rule.
The surrender of your policy may result in taxable gain
If you surrender your cash value life insurance policy, any
gain on the policy will be subject to federal (and possibly state) income tax.
The gain on the surrender of a cash value policy is the difference between the
gross cash value paid out (plus any loans outstanding) and your basis in the
policy. Your basis is the total premiums that you paid in cash, minus any
policy dividends and tax-free withdrawals that you made.
You may be able to exchange one policy for another
without triggering tax liability
The tax code allows you to exchange one life insurance
policy for another (or a life insurance policy for an annuity) without
triggering current tax liability. This is known as a Section 1035 exchange.
However, you must follow the IRS's rules when making the exchange.
When in doubt, consult a professional
The tax rules surrounding life insurance are obviously
complex and are subject to change. For more information, contact a qualified
insurance professional, attorney, or accountant.