There are three phases of a life insurance policy, at all of which there are tax implications:
- Premium payments
- Cash value accumulation
- Death benefit proceeds
Not all policies will have all 3 phases, for example a term policy does not build up cash value, or a whole life policy can be surrendered for its cash value prior to maturity.
Premiums are usually treated as a regular expense, and are therefore not tax deductible. Unlike other expenses or types of insurance where they may be “written off,” life insurance is considered an asset and thus the premiums do not come off of your balance sheet upon tax filing.
There is one exception to this rule, wherein the premiums of a policy can be deducted from your gross income, and that is when the life insurance policy is within a tax qualified plan such as a 401k. There are many regulations as to how this may be setup and it is usually not practical or efficient.
However, in short, the life insurance policy may not be more than 49% of the qualified plan holdings. The life insurance aspect of the policy does still have a taxable gain to the insured as well. So even though the premiums will be tax deductible, there will still be a tax bill for the taxable benefit of having a life insurance policy. This cost is either the price of a one year non renewable term, or based on the tables released by the IRS.
Because of this taxable benefit, a term policy is not a viable option within a qualified plan as the benefit would be rather small. (I.e. The difference between the actual level premium term cost and the one year term premium is not drastic enough to warrant the costs and difficulties of creating a 401k. That difference will also decrease every year the policy is in force as the insured ages.)
Upon distribution of the qualified plan, there will be taxes, just like any other qualified distribution. However, over here the correct strategy should be used to enable tax free access to the death benefit as will be discussed later on in the benefit distribution section.
Cash Value Accumulation
The cash value in a life insurance policy builds up on a cash deferred basis due to IRS code 7702. What this means practically is, all the guaranteed cash value, plus the dividends deposited into the policy will be received and grow without any taxes being assessed.
The reason why it is tax deferred and not tax free is, upon withdrawal from the policy due to either partial or full surrender, there will be a tax bill on all amounts above the basis paid into the policy. That amount will be taxed at regular income.
In order to avoid paying any taxes on the policy, once the basis is withdrawn from the policy, you can loan the remaining amount needed, provided that it doesn’t lapse the policy. Being that it is a loan for personal use, it will not be taxed. Be mindful that loans do affect the policy values and will accrue interest. Depending on the insurance company and type of policy, the dividends can be affected as well. (Referred to as “Direct Recognition” wherein the insurance company adjusts the dividend interest rate due to the loan being taken from the policy.)
The chart below illustrates the true advantage of having tax deferred growth. The IRR is significantly higher when you factor in the taxable equivalent of the policy.
Another situation where the cash values can be taxable is when the policy is a Modified Endowment Contract (MEC). When a policy is a modified endowment contract it operates in a manner similar to that of a qualified retirement plan. Meaning, the cash values would still grow tax deferred, however distributions would be different.
Unlike a regular life insurance policy that is not a modified endowment contract, where you can withdraw the basis first tax free. (First in first out “FIFO.”) With a policy that is a modified endowment contract, everything is taxed immediately upon withdrawal until all the gains are received and only then is the basis tax free. (Last In Last Out “LIFO.”)
Additionally, all distributions prior to age fifty nine and a half are levied with a ten percent penalty.
Here is a link to IRS code 7702 discussing tax deferred cash value growth as well as Modified Endowment Contracts.
Death benefit proceeds
Is the life insurance payout taxable? One of the most advantageous tax benefits of life insurance is the tax free life insurance death benefit. The life insurance payout is not taxable in almost every situation. Meaning the beneficiaries do not pay taxes on life insurance policies and payouts. In other words, when the grieving family receives a check from the life insurance company, no tax will be deducted from the death benefit. So a $1,000,000 policy means an actual $1,000,000 benefit to the beneficiaries of the policy. This applies to all types of life insurance policies. Whole Life insurance is not taxable. Universal Life insurance is not taxable and Term Life insurance is not taxable.
There are some exceptions to this rule however which we will go through now.
“The Unholy Trinity”
This refers to a situation where the owner, insured and beneficiaries are all 3 different people. In this situation the owner of the policy can actually have to pay a gift tax if the amount of the policy is above the life exclusion amount of tax free gifts allowed. It is therefore always advisable to make sure that either the owner of the policy is the insured, as is done in most cases. If that is not possible then the beneficiary can be the owner. The payor of the policy does not have to be an official party to the policy as long as they have insurable interest it should be enough.
As discussed above, a life insurance policy can be purchased within a qualified tax deferred retirement plan. As mentioned there are advantages to this due to the premiums being tax deductible. However, aside for the fees that go into setting up and maintaining such a plan, another major disadvantage to such a plan is the taxation of the death benefit. Now, not all of the death benefit is taxable, however the amount of the death benefit which is equal to the cash value minus the taxable benefit of premiums paid (which were already taxed) is taxed.
A $1,000,000 death benefit with $350,000 of cash value that over the lifetime of the policy had a “taxable benefit” that the insured paid of $25,000 would be tax free for the amount of $675,000. The remainder would be taxed at ordinary income tax rates.
Purchasing a life insurance policy to cover estate taxes is a common strategy due to the tax favorability of life insurance contracts. However, even though the pure death benefit of the policy is tax free, no matter the amount of the policy, the amount of the death benefit does get added to the estate for total estate calculations. Therefore a couple who had a fifty million dollar estate that owned a ten million dollar life insurance policy would be considered to have a sixty million dollar estate for estate tax purposes. The solution to this conundrum is to purchase the life insurance policy within an irrevocable life insurance trust so that it does not get included into the calculation post mortem. Understandably this is a more complicated situation and a life insurance advisor and lawyers should definitely be involved in the setup of such a strategy.
Can life insurance be claimed as a tax deduction?
In most cases the answer is no. However, if the policy is set up within a qualified plan properly then yes the premiums can be deducted from your income.
Can the IRS take life insurance money?
No, life insurance payouts are not taxed in most cases. The few exceptions are listed above in this article.
Do you get a 1099 for life insurance proceeds?
No, in almost every situation the life insurance payout is not taxable. The exceptions however are listed in this article above.
Do you get taxed on whole life insurance?
In the vast majority of cases, Whole Life policies grow tax deferred and can be accessed tax free as well through loans. Likewise the death benefit of the life insurance policy is tax free. The outlying cases when this is not the case are enumerated and explained in this article above.
Do you have to pay taxes on whole life insurance?
Most of the time both the cash value accumulation and death benefit are untaxed. For more details and exceptions please read the article above.
Do you have to report inheritance money to the IRS?
Luckily the IRS allows for many millions of dollars to pass to heirs untaxed. However if you do inherit many millions of dollars, please do consult an attorney and financial professional as to what the recommended procedure would be.
Do you pay taxes when cashing in a life insurance policy?
When receiving the death benefit as a named beneficiary of a policy you will mot have to pay taxes.
Does life insurance reduce taxable income?
Almost always unfortunately not. There is a way to do it, which is explained in this article, and it requires setting up a qualified retirement plan and many other details.
How can I avoid paying taxes on life insurance?
As long as it is a regular policy owned by the insured or beneficiary the death benefit will be completely tax free.
How is whole life insurance taxed?
As a rule, it is not taxed. That being said, if you surrender the policy you will have to pay ordinary income taxes on the amount of cash value above the basis.
Is insurance payout considered taxable income?
No, and it is therefore tax free!
Is life insurance tax free?
Yes! Death benefits of life insurance policies are tax free.
Is the cash surrender value of a life insurance policy taxable?
While in the policy, no. Upon surrender, or withdrawal if not taken as a loan, then the amount of value above the basis will be taxed as ordinary income.
Is a whole life insurance death benefit taxable?
Is Whole Life insurance tax deductible?
The premiums are not tax deductible. For exceptions and explanations please read this article above.
Is whole life insurance taxable to the beneficiary?
What are the tax benefits of life insurance?
Tax free death benefit. Tax deferred and potential tax free cash value growth.