• Harry N. Stout

Life Insurance’s 10 Most Misunderstood Income Tax Considerations


As we have discussed in a prior post, life insurance can be a very effective tool to protect against financial risks in the FinancialVerse. It provides money to beneficiaries to do things such as fund college, pay off a mortgage, create lifetime income, and much more. Congress has understood the power and social good that life insurance provides. It has acted to bestow certain tax advantages to the product, but with certain restrictions and limitations. In particular, life insurance products offer income-tax-free benefits, tax-deferred income accumulation, tax-free loans, and other financial benefits.


Most consumers do not understand these tax benefits and restrictions and often times do not use them. In my view, these benefits represent one of the major tax breaks that exist for the vast middle class in our country.


Let’s take a look at the ten most misunderstood tax considerations of life insurance products. As you manage your personal risks and think of tax questions relating to life insurance products, I encourage you to consult a professional. The tax rules surrounding life insurance are sometimes complex and are subject to change. For more information, contact a licensed insurance professional, attorney, or accountant.


Congress and the Law

Congress has written laws as part of the Internal Revenue Code that pertain to the tax aspects of life insurance products. It’s not required for a you as potential buyer to have an in-depth knowledge of the ins and outs of the entire US tax code. There are income, estate, and other tax considerations to these products. A financial advisor can help you navigate the details and determine exactly what is and isn’t taxable.


The Ten Most Misunderstood Income Tax Aspects

I have presented the list in question-and-answer format to help you gain a better understanding of these topics.


1. Will my beneficiaries have to pay income taxes on the proceeds of the life insurance policy if I die? Whoever receives the proceeds or 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 $300,000 death benefit, your beneficiary under the policy will not have to pay income tax on the receipt of the $300,000.


One exception to this rule is that different income tax rules may apply if the $300,000 death benefit is paid in installments over a period of time (e.g., five years) instead of as a lump sum. If that occurs, 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.


Although your life insurance policy may pass to your beneficiaries income tax free, it can affect your estate tax. If you are the owner of the insurance policy, it will become a part of your taxable estate when you die. You should make sure your life insurance policy won’t have an impact on your estate’s tax liability. If your spouse is the beneficiary of your policy, then there is nothing to worry about. Spouses can transfer assets to each other tax free. But if the beneficiary is anyone else (including your children), the policy will be included as part of your estate for estate tax purposes. For example, suppose you buy a $1 million life insurance policy and name your daughter as the beneficiary. When you die, the life insurance policy will be included in your taxable estate. If the total amount of your taxable estate exceeds the then current state or federal estate tax exemption, then your policy proceeds will be taxed.


The federal estate tax exemption is $11.4 million for 2019, but the limits for each state vary.

In my opinion, readers with large estates (over $1 million) should work with a licensed financial professional to plan how life insurance can be best positioned in their individual circumstances and consider their state of residence to avoid unnecessarily paying estate taxes.


2. Are life insurance premiums tax deductible? Life insurance premiums are considered a personal expense and are not tax deductible. Even if you are a contractor or part-time worker paying for your own policy because you don’t have access to an employer policy, you cannot deduct premium payments from your taxes. Policyholders also can’t use a flexible spending account or health savings account to pay life insurance premiums.


3. My employer provides me with coverage. Is this benefit taxed to me? 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. This amount will be calculated by your employer and included on your annual Form W-2 of taxable wages. It will be disclosed as a separate line item, and you will need to include this amount in your calculation of taxable income.


4. My policy accumulates cash each year. Do I have to pay tax on the interest earned on the policy? Some life insurance policies (e.g., permanent life policies such as whole and universal life) have a cash value component. As the cash value grows, you may ultimately have earned more money in cash value than you paid into the policy in premiums. Generally, you are allowed to defer income taxes on these earnings as long as you don’t sell, withdraw from, or surrender the policy. If you do sell, withdraw from, or surrender the policy, the difference between what you get back and what you paid in is taxed as ordinary income.


5. My policy pays an annual dividend. Are these taxable? Some policies, known as participating policies, pay annual dividends. An insurance dividend is the amount of your premium that is paid back to you if your insurance company achieves lower 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 nontaxable return of premiums. As long as you don’t get back more than you paid into the policy, you are merely recouping your costs, and no income tax is due.


6. I just took a $10,000 withdrawal from my whole life policy to put a new roof on my house. How are withdrawals from cash value policies taxed? If you withdraw cash from a cash value life insurance policy, the amount of withdrawals up to the amount you paid into the policy will be tax free. Generally, the amount paid into the policy or what is called 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 (your 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. Please remember that if you withdraw part of your cash value, the death benefit available to your survivors will be reduced.


7. My policy has a loan provision, and I would like to take out a $10,000 loan. Are loan proceeds taxable to me? 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 remains in force. Please remember that if you take out a loan against your policy, the death benefit and cash value of the policy will be reduced in the event of your death and the loan is still outstanding.


8. Is the interest on my policy loan deductible? 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.


9. I am considering surrendering my cash value policy. What tax concerns should I look out for? 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 is treated as ordinary income, not capital gain. 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.


10. Can I exchange my existing policy for a new one with living benefits? 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 specific rules and time constraints when making the exchange. Please consult a tax professional if you are looking to make an exchange to make sure it is done correctly.


Summary

Life insurance policies, particularly permanent policies that accumulate cash amounts, have been granted significant tax advantages by Congress and the Internal Revenue Service. Most people are unaware of these tax benefits and do not avail themselves of them. There are numerous tax questions that relate to the purchase, use, and sale of life insurance policies. This post has been designed to highlight the key tax aspects of premiums, death payments, and loans. The tax rules surrounding life insurance are obviously complex and are subject to change. For more information, contact a licensed insurance professional, attorney, or accountant.


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