Life insurance provides your family and loved ones with a vital financial safety net in the event of your death. But with a variety of life insurance policy options available, many people wonder exactly how to handle their policies when it comes to filing taxes. The good news is that in most cases, you do not need to pay taxes on life insurance. However, there are a few exceptions. So, to clear up some of your tax worries here is a quick primer on life insurance and taxes:
One common life insurance tax question has to do with whether or not policy premiums are considered a deductible expense. Unfortunately, the answer is no. Your life insurance policy is considered a personal expense, and therefore, your premiums are not tax-deductible. This goes for all policies regardless of the provider. However, there are a few small exceptions. For instance, if your life insurance premiums are included in your alimony payments, they may be deductible.
Life insurance policy premiums required by divorce settlements and alimony agreements before 2019 often are tax-deductible. If the policy was issued before the divorce decree, this tax deduction isn’t permitted. This rule was updated in 2019. Due to these changes in tax laws, deductions for life insurance policy premiums aren’t allowed for divorce decrees in 2019 and forward.
There are several ways to avoid or lessen the amount of taxes you have to pay on your life insurance premiums. This reduction is viable, whether you are an individual or a business owner. In some situations, a simple change can help you save money. Other circumstances need a more proactive strategy.
For businesses that provide their employees’ life insurance benefits, the premiums they pay are considered a deductible expense on their tax returns. The business entity cannot be a beneficiary of the policy to qualify for the deductions. This deduction is only available for the first $50,000.00 of insurance coverage per employee. Amounts above this are considered wages and are taxed as such. These premiums must be reported on all W-2 forms as income.
In certain business situations, the tax deduction on premiums doesn’t apply, such as when one spouse is the owner and the other an employee. If the owner provides life insurance to the employee and is the beneficiary of the life insurance policy, the premiums are not tax-deductible.
Payouts to Beneficiaries
Again, in most cases, your beneficiaries will not have to pay taxes on the proceeds from your policy. However, if your estate is large enough to be taxed ($5.45 million and above), your life insurance benefits will be taxed as part of your estate unless, at least three years before your death, you transfer your policy to an irrevocable trust.
An irrevocable trust agreement separates your life insurance policy from your taxable estate. Your estate includes your assets, such as bank accounts, real property, and life insurance policies. You determine who holds the trust for you. Any premiums due to your plan will be automatically paid on time by the trust. The trust will also state who your beneficiaries are, including any minor children, and ensure they receive their benefits according to your requirements set up in the agreement. Trust ownership creates a safe harbor for your resources.
A trust is a three-party agreement. The first party is the owner of the assets. This individual or business entity, also called the grantor, places the assets into the trust by a legal document. The grantor also assigns a person or business entity as the trustee. The trustee is the legal holder of the trust and must abide by the requirements set up in the document. Beneficiaries are the third party. They are anyone that will receive benefits from the trust. The terms of an irrevocable trust agreement must have the approval of all beneficiaries to be changed.
Another reason your benefits might be taxed is if your beneficiaries opt to take their payouts in installments, rather than in a lump sum. In this case, your insurance company would have to pay interest on the balance of your benefits, and that interest would be subject to income tax.NOTE: Payouts to spouses are exempt from taxation. So, even in the event that your estate is large enough to be taxed, your spouse’s benefits will be tax-free.
Permanent life insurance policies accumulate cash value over the life of the policy, which are not subject to income tax. And if you decide you no longer want your permanent life insurance policy, you can surrender it for a lump sum. However, if your surrendered policy has built up more cash value than you paid in, you would owe income taxes on the amount that exceeds your original investment in the policy.
If your insurance provider is a policyholder-owned mutual insurance company, you might receive annual dividends, which are not taxable unless the amount you receive is more than you’ve paid into your policy.
Dividends from your life insurance policy are payments made to the policyholder from profits the insurance company has made. These payouts are taxable income if they go to the policyholder, and the accumulated interest exceeds the total of premiums paid. Tax penalties can be high on some dividends. If you withdraw life insurance dividends before you reach the age of 59 ½, you may be subjected to a penalty tax of 10% or more.
There are a few exceptions to this rule. Premiums aren’t taxed when the dividends are from single-premium policies or when the cash value of the plan exceeds premium totals.
In short, the important thing to remember is that in the vast majority of cases, your life insurance benefits are not taxable and do not need to be included as income when you file your income taxes. Only in the event of interest accrual, or if the cash value of your policy exceeds what you paid in premiums, will you need to pay taxes on life insurance.
Laws and Life Insurance
Laws regarding tax deductions are always changing. And, so are rules regarding life insurance policies. Your tax accountant can help you navigate the ever-changing landscape of income tax returns. Likewise, your life insurance agent can guide you on changes to your policy. Meeting with both professionals yearly will ensure your life insurance coverage is adequate, and you are paying the lowest taxes possible on your premiums.