One of the key ways to take the sting out of paying taxes is to see what you can all list as a deduction. It’s surprising what might be a deduction, but life insurance premiums are not something you can list as a deduction. So the answer to “Is life insurance tax deductible?” is “no, at least in 99% cases”
To make matters confusing, you may see that your earnings on a life insurance policy are what is known as “tax-deferred” and when you withdraw from the cash value account of permanent life insurance policy, it is also tax-free. Life insurance does have tax benefits, especially when compared to other retirement planning options. Below we’ll look at how life insurance ties into taxes and what kind of benefits you could find.
- Is the Premium of Life Insurance Tax Deductible?
- In What Cases is Life Insurance NOT Taxable?
- How Does Life Insurance Compare to Other Retirement Savings Options on Taxation Aspect?
Is the Premium of Life Insurance Tax Deductible?
No, in at least 99% cases. In general, life insurance premium is not tax deductible. However, there are two unique exceptions:
- If you buy a permanent life insurance policy, give the policy to a charity organization, and name it to be the beneficiary. When you pass away, the charity organization will receive 100% death benefit from the policy. In this case, the premiums that you pay for this permanent life insurance policy is tax deductible.
- When you divorce, as a part of divorce decree, you ex-spouse pays the premium of your life insurance policy, the premium is tax deductible as alimony.
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In What Cases is Life Insurance NOT Taxable?
One of the greatest benefits of life insurance is that it is often not subject to being taxed. For example, death benefits paid from a whole life insurance policy are generally free from federal income tax.
What’s more, according to the IRS, life insurance proceeds you get as a beneficiary when the insured dies are not part of gross income and you do not have to report them.
Where it gets more complicated is when you have a policy transferred to you, ie. you buy the policy from someone, you will pay premiums going forward, and become the beneficiary of the policy. Logically, you will receive death benefit from the policy when the insured dies. However, not 100% death benefit you receive from the policy is free from income tax. You will need to pay income tax on the portion that is called capital gain. For example, you buy a $300K whole life policy from your older brother for $150,000. You pay the premium for the next 10 years, $2,000 a year, total $20,000 for 10 years. Your older brother passes away in the 10th year, you will receive the death benefit of $300,000 from the policy. However, you have to pay income tax on $130,000, which is the result of $300,000, less the sum of $150,000 and $20,000 ($2,000*10).
When you withdraw from or borrow against the cash value account of an indexed universal or variable universal life insurance policies, the withdrawal or borrowing amount is also free from income tax. That’s the reason why indexed or variable universal life insurance policies are popular for retirement planning.
>>MORE: Understanding Indexed Universal Life Insurance: Why Is It Good for Retirement Savings?
However, if you surrender your cash value life insurance policy and receive the cash surrender value amount, you have to pay income tax on this cash surrender value, net off the total premiums that you have paid and the surrender charge.
What’s more, according to the U.S. Office of Personnel Management, living benefits (or accelerated death benefits) are not subject to federal income tax. However, some states vary. What this means is if you have an accelerated death benefit rider that pays out a portion of your death benefit in the case of terminal or chronic illness or disability, that amount is also not federally income taxed.
Please note that these are only guidelines and you should always consult with a tax professional.
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How Does Life Insurance Compare to Other Retirement Savings Options on Taxation Aspect?
While the answer to “is life insurance tax deductible?” is no, you can see above that life insurance has some solid tax benefits. But how do these compare to other savings options, particularly those focused on retirement? Below we’ll outline some of the basic tax regulations for common retirement options and see how they compare to a life insurance policy.
- 401K: Tax-deferred, generally you pay the income taxes when you withdraw the money
- IRA: Withdrawals are taxed as regular income based on your tax bracket.
- Roth IRA: Withdrawals are tax-free if you’re 59 ½ or older and the account is at least five years old. This is the same as withdraw from cash value life insurance policy. However, unlike a cash value life insurance policy that there is little limit of annual contribution, the maximum contribution to a Roth IRA is $6,000 in 2020 if you are younger than 50 years old. If you are 50 or older, you can add another $1,000, making $7,000 the maximum contribution.
- A mutual investment account like Vanguard: Typically owe taxes on gains. Can invest in a way that is “tax efficient” through minimizing trading and making tax-exempt investments.
>>MORE: Tax Benefits of Life Insurance: Compare with Other Retirement and Investment Options
As you can see, retirement funds typically don’t outrun taxes forever. At some point down the line, that money is taxed, usually at the point of withdrawal. The exception is the Roth IRA if you meet certain age requirements.
So if you’re looking for a way to access funds or pass on money tax-free, a life insurance plan can be the way to do it. As mentioned above, money paid to your beneficiaries upon your death is not subject to income tax. On top of that, if you choose to withdraw or take a loan against the policy, that is tax free too.
Where life insurance policies and retirement accounts can be similar is that you’re growing money tax-deferred on the cash value of the policy. However, with life insurance, you can have the benefits of tax-deferred cash growth, tax-free withdrawal or loans, and the benefits of passing on non-taxable benefits to the ones you leave behind. With retirement account, you have to pay income tax whenever you withdraw.
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Final Thoughts
- Is life insurance tax deductible? No, life insurance premiums are not tax deductible.
- The death benefit that is paid out to beneficiaries after you die is non-taxable.
- Interest earned on the cash value is often tax-deferred.
- Withdraw from and loans against a policy are income tax free.
- Retirement accounts tend to grow tax-deferred as well, often being taxed at the time of withdrawing the money.
- With a life insurance policy, you have the benefit of tax-deferred cash growth like a retirement account, but you can withdraw tax-free and pass on a death benefit income tax-free.
- Again, always consult with a tax professional. These rules are merely what is typical and can change.
