Is Life Insurance Tax Deductible: Tax Benefits You Should Know About
The ultimate goal of a life insurance policy is to financially secure your loved ones after your death. Policyholders may also experience other benefits, such as tax exemptions.
In this guide, you’ll learn the best ways to deduct insurance for tax purposes. We’ll also take a look at some business and health-related deductions that you might be overlooking.
Keep reading to learn more about how insurance can affect your taxes!
What Are Tax Deductions?
Tax deductions aim to reduce an individual’s tax liabilities. Each state has its own tax codes that determine which expenses taxpayers can deduct from their gross taxable income. Deductions are either standard or itemized.
Standard deductions vary annually and will depend on a taxpayer’s income. The amount is predetermined and doesn’t require additional calculation on the part of the taxpayer.
On the other hand, itemized deductions reduce your taxable income by subtracting various medical, interest, job-related, and miscellaneous expenses. If itemizing your deductions, you must adhere to threshold amounts under the IRS.
Although similar, don’t confuse deductions with credits – deductions shrink your total taxable income, while credits cut from your final bill.
Is Life Insurance Tax-Deductible?
Because there are no state or federal mandates that require you to purchase a life insurance policy, life insurance premiums are considered a personal expense. According to the Internal Revenue Service (IRS), when you buy life insurance for yourself, it’s equivalent to purchasing any other consumer product.
Personal expenses are generally not deductible – premiums are no different in this regard. However, some aspects of life insurance are tax-deductible, including the instances listed below.
Tax-Deductible Exceptions For Life Insurance Premiums
Individual life insurance usually isn't eligible for a deduction. But if you buy life insurance for another person or organization – say, your employees or an ex-spouse – you may be able to deduct the premium payments from your taxes.
Here are some of the exceptions:
Group Life Insurance
Group life insures employees on an employer-owned life insurance plan. Because group life insurance counts as a business expense, its premiums are deductible for business owners.
Employers can deduct life insurance premiums paid for employees for the initial $50,000 in benefits. However, any insurance coverage beyond this counts as earned wages and is subject to income tax. Businesses that offer deferred compensation or executive bonuses can also deduct premiums.
Keep in mind that life insurance premiums cannot be deducted from your taxes if the beneficiary on a group life insurance policy is the employer or the company itself. You also can’t claim a tax deduction on your employee benefits if you are legally married to your employer. This practice prevents business owners from benefitting from their spouse's insurance policy.
If you're a business owner and employed by your own company, you are entitled to deductions on business expenses. This includes health insurance coverage and legal or liability coverage. You are also entitled to deductions if you purchase life insurance in the interest of protecting your business assets.
You can use life insurance to protect your business in case you are forced to liquefy assets after death. Because liquidation results in the exchange of funds below market value, a life insurance policy can help a business come up with quick cash in case one of the employers/founders/owners dies.
Policyholders may also purchase life insurance to borrow money from it, keep a business afloat, or sell later on for emergency purposes.
Employees who can no longer perform professional services due to injury or illness can receive workers' compensation from their employer. Unlike unemployment compensation, workers’ compensation is not considered income and therefore not subject to income tax.
If your divorce settlement requires that you purchase a life insurance policy on behalf of your former partner, you can deduct this cost from your insurance premiums. However, if you already have an existing policy that names your ex-partner the beneficiary, you can't claim any tax benefits.
These deductions are only applicable to alimony agreements that were filed before 2019 due to recent tax code changes.
If you decide to donate your life insurance policy to a qualified charitable organization, you can deduct the gift tax. However, if a policyholder donates the cash surrender value on their policy (and not the policy itself), deductions aren’t applicable.
These standards apply to life insurance gifts that go towards educational facilities, religious organizations, and other types of charities. Laws regarding gift taxes may vary according to state.
Commonly Overlooked Medical Deductions
Looking to save more on taxes? Your medical expenses and health-related costs can help. Many of these are tax-free up to a specific limitation.
Let’s break it down below.
Health Savings & Medical Expenses
If you are eligible for a Health Savings Account (HSA), you can benefit from its tax-advantaged savings element along with your high-deductible life insurance policy. Not only do you contribute to the account using pre-tax income, but all subsidies are 100% tax-deductible. Any interest you earn using the account will also be tax-free.
With that in mind, you'll have to meet strict eligibility requirements to qualify for an HSA. Firstly, you can only apply for an HSA if you already have a high-deductible health plan (HDHP). Additionally, you can only contribute to an HSA in cash. If you have excess contributions, you’ll incur a 6% tax charge.
Between these restrictions and a high deductible, switching to an HDHP may not be worth the additional tax breaks.
For self-employed taxpayers, the Internal Revenue Service says that "overhead insurance that pays for overhead expenses you have during long periods of disability caused by your injury or sickness" is tax-deductible.
With that in mind, you can't deduct premiums on emergency coverage that shoulders lost earnings due to illness or disability.
Do You Have To Pay Taxes On Life Insurance?
As much as possible, you don't want to leave your loved ones with any financial obligations after you pass away. The good news is, with most policies, neither you nor your beneficiaries will have to pay taxes to claim the death benefit.
However, this isn’t always the case, especially if you have a policy with a cash value. Keep reading to find out when life insurance is taxable.
You Surrender Your Policy For Cash
Life insurance policies come with a cash value component, which you can grow and borrow against. A portion of your monthly or annual premiums goes towards building this component. Any interest earned is tax-free, which makes cash value life policies an attractive option for those looking to grow their retirement savings.
Like any savings account, whenever you take money out of the policy, the cash surrender value drops. If you decide to surrender your policy, you can only receive whatever is in your current cash account minus any administrative fees, active loans, and termination fees. So, while borrowing from your cash value can be handy in emergencies, it reduces how much money you can get if you surrender the policy.
You'll also be taxed on your cost basis, which is the portion of your cash value component that comes from your premiums. This is basically your cash value minus interest and dividends.
You Accept Annual Dividends
If you are both the policyholder and owner/stakeholder of the insurance company, you will receive cash dividends depending on how much profit the company makes every year. If you funnel your dividends into your cash value component, or they surpass the amount of premiums paid in a given year, this can be taxed.
You Buy Your Policy From Someone Else
If someone decides that they no longer need their life insurance policy but don't want to surrender it for cash, they can instead sell it to someone else. Keep in mind that while coverage is transferable, the cash value account is not. The seller gives up any money accrued in the account, and the buyer won’t have access to it either.
The policy seller doesn’t have to worry about paying taxes on the sale. However, the buyer has to shoulder taxes on a portion of the life insurance death benefit.
Your Beneficiary Is Your Estate
Some policyholders choose not to name a beneficiary or select one who isn’t an immediate descendant. A grandparent, for instance, can name their grandchild (known as a “skip person”) or even their estate as the death benefit beneficiary.
Naming your estate as a beneficiary can cause potential tax problems if the proceeds become entangled with estate probate. During a probate assessment, an estate can become subject to property and inheritance tax.
Calculate your taxable estate by subtracting any unpaid loans on your cash-value account from the total estate value. These guidelines may differ from state to state, so ensure that you consult with your financial advisor or look up local laws.
You Want To Change Health Insurance Terms
Let’s say you started with a permanent policy and want to switch to more affordable term life policy premiums. If you managed to accumulate any interest in your previous policy via the cash account, your insurance company can choose to tax this upon the surrender of the policy.
Unfortunately, life insurance policies can’t be claimed as a tax deduction – except under unique circumstances. If you have a group life insurance contract, are self-employed, or want to make a charitable donation, you can enjoy a few tax exemptions on your life insurance premiums.
Make the most of these benefits by doing your research, choosing the right insurance company, working with a qualified financial advisor, and reading in between the lines of your contract.
Learn more about maximizing tax benefits and deductions on your life insurance premiums with Wesley Insurance, LLC. We are committed to servicing your insurance and tax-related inquiries!