What are the basic principles of life insurance taxation?


The general assumption is that life insurance is tax-free. However, there are a number of small but very important details that one has to take into account when looking to buy a policy or making changes on a current one.

If you are interested mainly in whether your death benefit will be income tax free or taxable, read “Do I need to pay federal income tax on life insurance proceeds?” – you will find there all the information you may need on the subject.

As for whether life insurance premiums are tax deductible, just read on:

Is life insurance tax deductible?

Premium payments on individual life policies are non-deductible as they are considered personal expenses. The exception is when the premiums are paid for group life insurance policies by the employer as these are considered as business expenses.

  • Are life insurance settlements tax deductible?

    Proceeds paid under a life insurance policy to a designated beneficiary are free from federal income tax. However, if the proceeds are distributed via a settlement option where interest is earned, the interest part is deemed taxable as ordinary income. For policy proceeds to be free from income tax, it has to be transferred to an individual with an insurable interest in the insured person's life (could be a partner or children of the insured or it could be a corporation wherein the insured is a shareholder).

  • Are life insurance premiums deductible when used to pay estate taxes?

    No, they are not. Personal life insurance premiums are deemed as personal expenses and therefore not deductible. According to the IRS, it does not matter whether the amounts were shouldered by the insured individual or by someone else, or, whether it is for commercial or government life insurance. The only ways they can be claimed as deductions are when they are payments of alimony or contributions to charity.

  • Are cash value life insurance premiums deductible?

    No, these are not deductible. However, they are tax-deferred. Any growth in the cash value of a policy is tax-deferred until the time the policyholder withdraws the money. When that money is taken out it becomes subject to tax.

  • Are life insurance paid up additions taxable?

    No, they are not. Many insurance companies use dividends to cover paid-up additions. In a good year dividends can accumulate and their cash value can grow. That cash value is not subject to tax.

  • Is group life insurance tax deductible?

    Yes, if the premium payments made toward the policy is an expense of a business. For example, the employer shoulders the cost of a group policy for his employees. That cost may be deductible as it is a business expense.

How does taxation of life insurance fringe benefits work?

Many employers offer group life insurance to their workers as a fringe benefit. That insurance is tax-exempt unless it goes over $50,000. Any coverage amount that goes over $50,000 is subject to Medicare and social security taxes. When filing, the excess amount will be included as part of annual income. This should be indicated in box number 12, code C of the W-2 form.

The $50,000 limit is applicable to policies which are paid for by the employer or which the employer makes arrangements that get the premiums paid. In addition, policies that took effect on the 17th of August 2006 and are employer-owned, have to satisfy the following conditions:

  • That there is written notice by the employer that there is intention on his part to have his employees insured with the policyholder as the beneficiary.
  • The one insured has to acknowledge in writing that they consent to being insured.
  • That the one insured is under employment any given time within the year before his or her death or be a key worker during the the signing of the contract.
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