Is Life Insurance Taxable? What You Need To Know To Protect Yourself

You've taken out a life insurance policy to make sure your family is protected in case of your death. But is life insurance taxable? Answering this question can help you best prepare for the future. They say the only two constants in life are death and taxes - but you can at least take away the mystery by learning about how taxes affect your life insurance.
We're here to help. In this guide, we'll show you everything you need to know about life insurance and taxes. Keep reading to learn whether you or your family will need to pay taxes on your life insurance.

Also read: Payroll Tax Vs Income Tax - The Ultimate Guide

Is Life Insurance Taxable?

The short answer is no - most of the time. The IRS says that the benefits from a life insurance policy typically won't be subject to federal taxation - as long as they were obtained due to the policy-holder passing away. If this is the case, the beneficiaries don't have to report the benefits they received, or add it to their gross income when they file tax returns.

However, if they receive interest above the policy amount, that interest is taxable and will need to be reported on a tax return. For example, if the beneficiaries get their benefits in installments that have some interest, they can be taxed on the amount of the installment that was interest.

Life Insurance Tax Planning Ideas

That said, things can be much more complicated, depending on the situation. Understanding why life insurance is important is very different from actually understanding all the rules surrounding it. The rules also vary depending on your location.
Insurance products are constantly changing and becoming more complex, which makes it hard to keep up. In fact, insurance and investment cross paths quite often, which makes things even more complicated.
To keep these two things separate, a network of complex regulations has developed. Here are some tips and information to help you navigate that network more successfully.

IRS Requirements for Life Insurance Contracts

An insurance contract isn't officially a life insurance contract for tax purposes unless it meets the requirements of the state and the IRS. To get the best tax treatment, you need to meet the IRS' expectations of what defines a life insurance policy.

In this definition, the IRS looks at things like the amount of death benefit, premiums paid, the date it was issued, and the type of policy. These definitions help make sure investment vehicles can't be masked as insurance policies. An insurance company has to meet and enforce all of these rules regarding its policies.

Can You Deduct Premiums?

When you pay insurance premiums, the IRS doesn't let you deduct them on your taxes. Life insurance is a personal expense so it doesn't qualify for tax deductions.

Taxes and Employer-Paid Insurance

The initial $50,000 of coverage given by an employer-provided group isn't taxed, and you don't have to report it as income. But anything above that amount will become taxable income.

Also read: How Much Is Social Security tax?

How Do You Pay Your Premiums?

Even though your premiums aren't tax-deductible, it's important to know if you're paying them with money before taxes or after taxes. How your life insurance will or will not be taxed depends in part on this factor. If you buy your own life insurance policy or get it from your employer, it's probably paid for with after-tax money.

However, when your company lets you buy life insurance as part of a retirement plan, and you make contributions that are pre-tax, things may be different. Pre-tax contributions have some advantages when it comes to taxes. But you will have to pay a bit of tax on the value of what's called "pure life insurance" in your policy.

Pure life insurance refers to the difference between the death benefit and the total cash value of your policy. This can get a bit complicated, but most employers don't offer the option of buying life insurance with a retirement plan anymore.

When Insurance Proceeds are Part of a Taxable Estate

Sometimes, the proceeds from your insurance policy will become part of your taxable estate after death. This happens when you hold "incidents of ownership."

Incidents of ownership refer to being able to take out policy loans, change the beneficiary, or surrender your policy for cash. And, if the insurance policy is gifted to someone else three years or less from the date of death, the proceeds from the policy actually go back to your taxable estate.
If you don't want your policy to become part of your taxable estate, you should make someone else, such as a beneficiary, the actual owner of the policy.

Does Your Policy Have Cash Value?

If a part of your policy has a cash value, it can grow tax-deferred. Non-term life insurance policies, such as permanent life policies, might have these cash value components.

When the cash value accumulates, it might eventually exceed the amount that you paid in your premiums. If you don't surrender, sell, or withdraw from your policy, you can usually defer income taxes on the cash value gains. However, if you sell, surrender, or withdraw from your policy, the difference in the premiums you paid and what you receive gets taxed as income.

Will You Get Taxed on Dividends Paid?

Typically, you don't get taxed on the dividends paid.
Some life insurance policies, called participating policies, will pay dividends. These dividends are a part of your premium that's paid back if the insurance company has lower expense and mortality costs than originally expected.

The insurer pays the dividends using its surplus earnings. However, since this is a return of the premiums you paid, you shouldn't be taxed on these payouts.

Also read: Do You Have To Pay Back FAFSA?​​​​​​​

Protect Yourself From Surprises

Taking out a life insurance policy is important. But if you never ask "Is life insurance taxable?" you won't really know what you're getting yourself into. Keep this guide handy, so you'll know what to expect when it's time to pay taxes, and so your beneficiaries will too.
Need more tax tips? Check out our guide to federal tax withholdings here, or just create your paystubs today with our paystub creator now!