Introduction
Life insurance, while often viewed primarily as a financial safety net for beneficiaries, also carries significant income tax implications depending on how benefits, cash values, and premiums are handled. The tax code’s definition of life insurance is complex, and qualifying policies may offer substantial income tax advantages, including tax-deferred growth of cash value, tax-free death benefits, and in some cases, tax-free distributions. Understanding the rules governing living benefits, policy exchanges, dividends, and premium deductibility is essential for policyholders and beneficiaries to maximize the tax benefits and avoid unexpected liabilities.
What is life insurance?
Webster’s dictionary defines life insurance as “insurance providing for payment of a stipulated sum to a designated beneficiary upon death of the insured.” However, the tax code has its own extremely complex definition of life insurance. If your life insurance policy qualifies under the tax code, an abundance of income tax advantages may be yours.
How is life insurance treated for income tax purposes?
Living benefits
Living benefits refer to amounts received under the policy before the insured’s death. They include withdrawals, surrender, loans, and dividends. They are generally treated as tax free to the extent that they don’t exceed your basis in the policy.
Death benefits
Death benefits are received by your beneficiary(ies) after your death (or by you before your death, if the death benefits are qualified accelerated death benefits). See Riders. Death benefits are generally not included in income.
“Inside buildup”
Inside buildup refers to income earned on the premiums (or, more specifically, the part of the premiums that does not cover mortality and administration costs) you pay on the policy, or, in other words, the cash value increase in the policy. As long as the inside cash buildup is not distributed, it is not subject to income tax.
Elections to make policies paid up
You can apply the increase in the cash value of your policy towards premiums you may still owe. This is called electing to make the policy paid up. Since you do not actually receive the cash value, it is not taxable.
Exchanges of life insurance policies
Under Code Sec.1035, life insurance policies on the same insured can be exchanged free of income tax, subject to certain limitations.
Government life policies
Government life policies, or National Service Life Insurance, enjoy a multitude of tax benefits:
- The increase in cash value is not taxable
- Income distributed if the policy is surrendered is not taxable
- Dividends are tax exempt
- Interest on dividends are tax exempt
Interest on dividends
Dividends are sometimes earned on life insurance policies. They can be distributed or they can remain with the policy. Dividends left with the insurer earn interest. Interest earned on policy dividends is taxable as ordinary income. Dividends are usually comprised of refunds of your premium payments and are not taxable. Dividends in excess of premium payments are taxable as ordinary income. Dividends issued by mutual life insurance companies are not eligible for capital gains tax treatment.
Gain on the surrender of a cash value policy
If you surrender your policy to the life insurance company, any gain realized is taxable as ordinary income to the extend the cash surrender value exceeds the net premium cost. The net premium cost is the total premiums you paid less any tax-free distributions you received. However, if the cash surrender value is less than the net premium cost, you are generally not allowed to deduct the loss.
Gain on the sale of a cash value policy
If you sell your life insurance policy with a cash surrender value, gain on the sale of the policy may be taxed partly as ordinary income and partly as long-term capital gain. The gain is the difference between the purchase price and the net premium cost (the tax basis). The net premium cost is the total premiums you paid less any tax-free distributions received, further reduced by the cost of insurance protection that was provided to you up to the time you sold the policy. Your basis is then recovered tax-free. The amount received in excess of your basis (not reduced by the cost of insurance protection) up to the cash surrender value is treated as ordinary income. Any additional amount of gain is treated as long-term capital gain, presuming you owned the policy for longer than one year prior to its sale.
Gain on the sale of a term policy
If you sell a term policy that you have owned for more than one year, the gain is generally taxed as long-term capital gain. The gain is equal to the excess of the purchase price over the net premium cost (generally, your premiums paid) reduced by the cost of insurance protection. In most instances, the cost of the insurance protection will equal the premiums you pay up to the date of sale. Premium payments made beyond the date of sale (e.g., you pay premiums on the first of each month and the date of sale is in the middle of the month) will equal your basis.
How are premiums paid for life insurance treated for income tax purposes?
Interest earned on prepaid premiums
You may pay your policy premiums before they are due. In this case, any interest earned on the advance payments is taxable.
Premiums in general
The general rule is that premiums you pay on personally owned life insurance policies are not deductible from your gross income as a personal expense.
Premiums constituting alimony payments
An exception to the general rule is if the premiums constitute alimony payments. Where you have made premium payments under a divorce or separation agreement, the payments are taxable as alimony to the non-insured spouse owner of the policy.
Premiums paid on certain policies assigned to charity
Another exception to the general rule is if you are paying premiums on certain policies assigned to charity. To qualify, the assignment must be:
- Irrevocable, and
- You cannot reserve the right to surrender the policy
Premiums paid by employers on group term policies
Premiums paid by an employer for a group term life policy are tax-free income to you, the employee. Also, your employer can deduct the premium payments from the company’s income.
However, if the group plan is discriminatory, or the amount of the coverage exceeds $50,000, employees may have to include all or a portion of the premiums in income.
- Discriminatory plans–If the plan is discriminatory, each key employee must include the greater of the actual cost of the insurance or the cost determined under applicable IRS tables.
- Plans where coverage exceeds $50,000–If your coverage under the group plan exceeds $50,000, you are taxed on the cost of coverage over $50,000 minus the amount you paid
Premiums paid by employers on individual or group permanent policies
Premiums paid by an employer on an individual (as opposed to group) policy on your (the employee’s) life is taxable income to you, unless the beneficiary of the policy is your employer. Premiums paid by an employer for a group permanent policy is also includable in your gross income for income tax purposes.
Conclusion
The income taxation of life insurance depends on the type of benefit received, how the policy is structured, and who pays the premiums. While death benefits from qualifying policies are generally income tax–free, living benefits and certain transactions—such as policy surrenders, sales, or loans—can trigger taxable income. Premiums are typically not deductible, with limited exceptions, and employer-paid coverage may have taxable components if certain thresholds are exceeded. By understanding these rules and planning accordingly, individuals and businesses can preserve the valuable tax advantages life insurance offers while avoiding costly surprises.
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Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
