Life insurance is often considered one of the most important items to have in your long-term investment plan. This type of insurance can help to provide financial resources to help the financial well-being and protect your loved ones.
One of the most common questions people have around life insurance is the tax deductibility of the premium payments. According to valuepenguin.com, about half of Americans believe their insurance premiums are tax deductible. Of those, men and those with high incomes were most likely to believe they can take a deduction, while baby boomers were least likely. Unfortunately, the quick answer on tax deductibility is generally, “no”. However, there are certain situations where the premiums can be tax deductible. Beyond that, there are a number of tax benefits from life insurance policies.
Why isn't life insurance tax deductible?
From the perspective of the IRS and your local state governments, paying your life insurance is treated as any other service or product expense as part of your family budget. Since there are no federal or state laws mandating that one purchases life insurance, it is treated as a selective purchase. Therefore, like your auto or home insurance, life insurance premiums are considered a personal expense, and therefore generally not eligible for tax deductions.
Tax advantages from a life insurance policy
While the premiums aren’t tax deductible, there are a number of tax advantages from a life insurance policy.
The most important benefit is your beneficiary typically won't have to pay income tax on the death benefit. However, some states might impose taxes in certain circumstances. Because individual policy premiums are paid with after-tax dollars, your beneficiaries will receive the death benefit tax-free. This is true if the proceeds are paid out entirely as a lump sum one time payment. However, if your beneficiary receives the life insurance payment as a series of installments, the insurer will typically pay interest on the outstanding death benefit.
Many parents with either your children or someone dependent on their income, will often request to have their life insurance death benefit paid in installments. In these cases, your beneficiary would have to pay income tax on the interest.
From an estate tax perspective, when you pass away, the executor of your estate fills out an IRS form as part of your estate tax return. Included in the total is the value of your insurance policies based upon the day you died. If your spouse is the beneficiary, the life payout is not taxed and will be passed along with the rest of the estate. Spouses generally have exemptions with regards to estate taxes, as it goes to the lifetime value of the estate.
If the payout goes to anyone besides your spouse, such as a parent or your children, the insurance payout will be added to the total value of your estate. This is typically not a problem, 99.9%+ of all American households will not exceed lifetime estate exemptions. However, in the cases of wealthy families, any amounts over the exemption will be subject to Federal and State estate and inheritance tax rules.
If your life insurance policy has cash value, another benefit is you will not owe income tax on the gains as long as you leave the cash value in your policy. In addition, for certain life insurance policies, according to the IRS, you can also withdraw money from your cash value without creating a tax liability as long as you withdraw less than what you paid in total premiums. However, if you withdraw more than what you've paid in premiums, you may owe taxes.
When are life insurance premiums tax deductible?
If you’re a business owner, you can deduct business-paid premiums for life insurance policies that are owned by company executives and employees. Unfortunately, the executive or employee that is insured will have to report the premium payments as income for tax purposes. Still, it’s a benefit for the insured as they get the value of life insurance, and only pay the appropriate tax rate on income.
Many companies have something commonly referred to as “Keyman” or “Keyperson” life insurance. This is a policy intended to help the company recover from the loss of an employee that contributes significantly to the business, if that person's death would reduce productivity or the company's value. People an employer might have covered by a key policy would potentially include top salespeople, executives and other decision makers, highly visible employees, and employees with unique knowledge or skill sets. It is tax deductible for the owner(s), however, the big difference on this type of policy is the business is the beneficiary of the proceeds of the policy.
Other instances where life insurance premiums may be deductible, include payment of alimony or as charitable contributions. There are specific rules, so you will need to consult your accountant or financial advisor to determine.
The bottom line
Life insurance is something you may consider adding to your financial plan if you're interested in providing a measure of security for your loved ones. Proceeds from a life insurance policy can be used to pay final expenses, eliminate outstanding debts, or cover day-to-day expenses.
Ultimately, looking beyond the tax deductibility of life insurance, in the grand scheme of things, the value of life insurance is the death benefit. Too often, when an income earner dies, the survivors are forced to quickly make tough and dramatic decisions. Not the best time to make significant financial decisions. Life insurance gives the beneficiaries a financial cushion if someone dies – helping pay off debts, pay the rent/mortgage, ongoing living expenses, and potentially funding college for children and grandchildren. If there are any tax benefits on top of that, it is a nice bonus.
For your specific situation, it is always good to discuss with a reliable financial professional how life insurance, and the accompanying tax benefits, can fit into a long-term financial plan.