Is life insurance tax deductible?
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Life insurance can help provide financial stability to your loved ones if you pass away, but like many things worth having, that benefit may come at a cost. You have to pay monthly or yearly premiums to keep your policy in force. Because it’s an important piece of financial protection, people commonly ask whether that cost is tax deductible.1 They also want to know if their beneficiaries will have to pay income taxes if and when life insurance benefits are paid out.
The short answer: Life insurance premiums generally aren’t tax income deductible, but when a death benefit2 is paid out, that is generally subject to income taxes. However, there are a few exceptions to both, so here’s what you should consider.
How tax deductions work
A tax deduction reduces the amount of a taxpayer's income subject to tax, which, in turn, usually reduces the total amount of income taxes owed. There are certain costs or expenses that may be classified as tax deductible by either individuals or businesses. Broadly speaking, if you make $100,000 a year and have $20,000 worth of deductions, you only pay taxes on $80,000, and because tax rates rise with income, you may also save by being in a lower tax bracket.
It's important to realize that a deduction is not a "dollar for dollar" reduction in taxes. A $100 deductible expense does not translate to $100 less taxes owed; your actual tax savings will be closer to your tax rate. So, if you're in a 20% tax bracket, a $100 deduction generally saves you $20 in taxes.
Are life insurance premiums income tax deductible?
In most cases, the answer is no. Life insurance premiums are not typically income tax deductible because they are considered to be a personal expense.
That said, there are a few circumstances that can make life insurance premiums deductible, such as in the following situations:
Small businesses that provide group term life insurance for employees and count the premiums as a business expense.
The premium is paid for by a business as part of an executive bonus plan.
The premium is included in some alimony arrangements from 2019 or earlier.
Is the death benefit from life insurance income taxable?
The death benefit— which is the sum paid to a policy’s beneficiaries upon the policyholder’s death— is typically free from federal income tax.
The IRS states that life insurance proceeds from a death benefit as a beneficiary aren’t included in your gross income, meaning you don’t have to report them. That said, any interest you receive is taxable, so you’ll need to report it as interest received.
This means that if your life insurance policy is for $500,000, your beneficiary will (typically) receive a $500,000 check without paying any taxes. If, however, they put that $500,000 payout into a savings account that generates interest, they will need to pay taxes on the accrued interest.
That said, there are some important exceptions to this rule. Your beneficiary may be responsible for taxes on proceeds from a death benefit under the following circumstances:
The death benefit is paid in installments or as an annuity
Most life insurance policies pay out a lump sum upon the death of a policy holder. However, beneficiaries can usually opt to receive the death benefit in installments, which can generate taxable income through interest on the principal. In this case, beneficiaries only owe taxes on the amount that exceeds the death benefit proceeds.
The transfer-for-value rule applies if the policy is transferred
A life insurance policy is a financial instrument with value that can, in certain cases, be transferred to another party in return for something else of value. The transfer-for-value rule says that when this happens, part of the death benefit is subject to income taxation.
If the transfer-for-value rule applies, the value of the items transferred for the life insurance policy is subtracted from the total death benefit. This remaining balance will be taxed as ordinary income.
There are some exceptions that would prevent the transfer-for-value rule from applying, even when a life insurance policy is transferred outright for something of value. These exceptions include transfers to:
A partner of the insured.
A partnership in which the insured is a partner.
The insured party under the contract, the insured’s spouse, or the insured’s ex-spouse in some circumstances if incident to a divorce under Sec. 1041.
A corporation in which the insured was an officer or shareholder (there is no exception for a transfer to a co-shareholder)
A person whose basis is determined in whole or in part by the transferor’s basis.
The estate exceeds the federal estate tax threshold
The IRS typically considers life insurance proceeds to be part of the deceased's estate. So, for example, if you have a policy with a $1,000,000 death benefit, it will add $1,000,000 to the value of your estate – the assets passed to your beneficiaries after you pass away. When an estate is very large, taxes must be paid before assets are distributed, but under current rules, estates are not taxed until they reach the federal estate tax threshold, which is $13.61 million as of 2024.
The policy has been surrendered
Some policies build cash value3— including whole life and universal life insurance policies. Generally speaking, you can “surrender” it back to the life insurance company.
If you surrender your life insurance policy, it cancels your coverage immediately, and the insurer sends you any surrender cash value in the policy. The cash surrender value is the total of the policy’s cash value after subtracting any surrender fees.
Since the cash value in your policy grows income tax-deferred over time, you will owe income taxes on any amount that exceeds the total value of life insurance premiums paid.
There are loans against cash value
Generally speaking, cash value life insurance allows for policy loans:4 You can borrow against cash value in your policy, which is used as collateral for the loan.
While these loans are generally income tax-efficient, you may owe income taxes on the amount borrowed if your policy lapses or you fail to repay the loan. It’s also important to remember that even if there aren’t tax consequences, you will pay interest on these loans.
Gift taxes may apply if the policy is transferred
Gift taxes are taxes on the transfer of property from one individual to another while receiving nothing (or less than full value) in return. It applies to the gift transfer of any type of property over $18,000in value ($36,000 for spouses splitting gifts). The $13.61 million exemption applies to gifts and can be used for gifts over $18,000 in value. Any portion of the exemption used for gift tax reduces the amount you can use for estate tax.
If you transfer your policy to another person (including a beneficiary) in exchange for nothing or less than the total value, the IRS considers it to be a gift. The cash value of the policy's worth may be taxed as a result.
State-specific rules with tax implications
Each state has its own tax code, and rules can vary significantly from state to state especially in regard to estate and inheritance taxes. If you are using life insurance for estate planning purposes, be sure to take into account any state-specific tax regulations that may apply to your situation.
It’s important to note that most life insurance benefits are paid out income tax free, and the situations described above are exceptions to this general rule. However, if you have any questions about your specific situation, it’s recommended to work with a tax or financial professional who can provide the specific guidance you need.
How to help mitigate tax implications
While many life insurance policy payouts are not taxed as income, there are plenty of exceptions when there may be tax implications.
To reduce tax implications on life insurance policies, you may want to ask a tax or legal professional about setting up an irrevocable life insurance trust. Policy holders can transfer the ownership of their term or whole life insurance policy to a trust, which then owns the policy. The trustee manages the benefits paid to the trust, distributing funds according to the terms set out in the trust agreement..
This process allows the person who establishes the trust to structure beneficiary asset distribution according to their specifications. If you want to release funds to beneficiaries when they come of age, for example, or reserve money for grandchildren's college funds, a trust can be set up to do those things.
Guardian can help
In the market for life insurance, but not sure whether term or permanent life insurance is right for your financial situation? Guardian can connect you with a financial professional who will listen to your needs and recommend different life insurance options to fit your needs and your budget.