For example, let's say you have a 20-year policy with a $500,000 benefit amount and you pay a $25 a month premium. That means that over the course of your policy, you'll pay $6,000 dollars in premiums. Knowing the tax regulations that apply to that $6,000 can help you make important financial decisions.
Tax deductions are expenses you can exclude from your taxable income for the year. The IRS designates specific expenses that can be deducted. They generally include costs such as:
There are additional deductions available if you're self-employed or run your own business. Many of the costs associated with running a small business are tax-deductible. At the end of year, you'll owe taxes on your total income, minus any deductions you claim.
Life insurance premiums are considered a personal expense by the IRS, so they are not normally tax-deductible. Although having a life insurance policy is important for your family's financial security, it is not considered essential.
However, on the plus side, life insurance payouts are not considered income. This means that your beneficiary won't be assessed taxes on the payout amount.
The exceptions to the general rule occur when you're paying premiums for a policy in someone else's name. You might be able to deduct your payments, in that case. This doesn't happen often, but can occur in some instances, such as:
If you own an LLC, an S corporation, or are a sole proprietor, you might be able to deduct premium payments. You can claim payments for your employees' premiums as a tax deduction if you offer life insurance as a benefit. However, neither the owner or the company can be the beneficiary of policy. This often comes up in the case of spouses who are in business together. For example, if your company is set up so that you're the owner and your spouse is an employee, and you are the beneficiary of your spouse's life insurance policy, you can't claim premium payments for your spouse as a tax deduction.
Additionally, you can only deduct premiums that go toward the first $50,000 of life insurance coverage. The IRS considers payments for life insurance above this amount to be wages and will tax your employees on it. Keep in mind that most people purchase life insurance policies with a face value of at least 10 times their annual income. This means that most people don't see much of a tax benefit from this exception.
Alimony agreements and divorce settlements that require you to purchase a life insurance policy on behalf of your former spouse might result in tax-deductible premium payments. However, it only applies if your alimony agreement or divorce decree went into effect before 2019. Tax code laws have recently changed, and this rule does not apply to current divorce cases.
Premium payments are tax-deductible if you name a charity the beneficiary of your life insurance policy and transfer ownership to them. In this case, you'll still be paying the premiums, but you'll no longer be the owner of the policy. It's important to note that you cannot deduct premiums paid if you have only named the charity as the beneficiary. You'll need to transfer ownership as well to take this tax deduction.
While premiums are taxable, the payout amount isn't normally taxed. Neither the policy owner nor the beneficiaries need to pay taxes on the benefit amount in most cases. However, there are a couple of exceptions to this rule.
Generally, any interest your policy gains can be taxed. This happens in two primary ways:
You can purchase someone else's life insurance policy. You'll pay the premiums and receive the death when the original owner dies. You might need to pay taxes on part of the benefit payout in this case.
You can borrow cash from your life insurance policy if you have a whole life policy with a cash-value component. This is called a cash surrender and works like a loan. You'll pay taxes on any amount you withdraw that exceeds the total of premiums you've paid so far. You'll also reduce the amount of the eventual life insurance benefit payout if you don't pay the loan back in full.
The tax rules don't change depending on the type of insurance you have. Both term life and whole life policies are subject to the same IRS regulations. The only exception is the taxation of cash withdrawals from a whole life policy.
You shouldn't plan on your premiums being tax-deductible, because in most cases, they won't be. However, the total cost of life insurance premiums is generally minor when compared to the benefit of your life insurance policy. That amount generally will not be taxed. This means your insurance premiums are a strong investment in your family's financial security, even if they're not tax-deductible.