Tax implications are important to consider when buying life insurance. The Internal Revenue Service (IRS) imposes different tax rules on different plans, and sometimes the distinctions are arbitrary. The following guide is meant to elucidate some of the tax implications surrounding life insurance premiums.

Key Takeaways

  • Life insurance premiums, under most circumstances, are not taxed—i.e. no sales tax is added or charged. These premiums are also not tax-deductible. 
  • If an employer pays life insurance premiums on an employee’s behalf,  any payments for $50,000 or more in coverage is taxed as income.
  •  Interest earned for prepaid insurance is taxed as interest income. 
  • Returns generated from whole life insurance policies are not taxed until the policy is cashed out. 

A person shopping for life insurance has many things to consider before making a decision. First, there is the distinction between term life insurance and whole life insurance. Term life provides coverage for a set number of years, while a whole life policy is effective for life. A policyholder also must calculate how much coverage they need. This depends largely on why they are buying life insurance.

A person who is only concerned with covering burial and funeral costs for their next of kin may opt for a death benefit of $20,000 or less. By contrast, someone with several dependent children, all of whom he hopes to send to college, often desires $500,000 or more in coverage. Further complicating the buying process is the sheer number of life insurance companies from which to choose. The Internet has made this process somewhat easier, with several sites dedicated exclusively to compare quotes from dozens of life insurance companies side by side.

Paying Taxes on Life Insurance Premiums

Unlike buying a car or a television set, buying life insurance does not require the payment of sales tax. This means the premium amount a policyholder is quoted when he obtains coverage is the amount he pays, with no percentage amount added to cover taxes. With that said, certain situations exist in which a policyholder is required to pay taxes on insurance premiums.

Employer-Paid Life Insurance

When a person's employer provides life insurance as part of an overall compensation plan, the IRS considers it income, which means the employee is subject to taxes. However, these taxes only apply when the employer pays for more than $50,000 in life insurance coverage. Even in those cases, the premium cost for the first $50,000 in coverage is exempt from taxation.

For example, a person whose employer provides them, for the duration of employment, with $50,000 in life insurance coverage in addition to their salary, health benefits, and retirement savings plan, does not have to pay taxes on his life insurance benefit because it does not exceed the threshold set by the IRS.

A person whose employer provides him with $100,000 in life insurance coverage, by contrast, has to pay taxes on part of it. The premium dollars that pay for the $50,000 in coverage he receives in excess of the IRS threshold count as taxable income. Therefore, if the monthly premium amount is $100, the amount that is taxable is the amount that pays for the additional $50,000 in coverage, or $50.

Prepaid Life Insurance

Some life insurance plans allow the policyholder to pay a lump sum premium upfront. That money gets applied to the plan's premiums throughout the plan's duration. The lump-sum payment also grows in value because of interest. The growth of that money is considered interest income by the IRS, which means it can be subject to taxation when it is applied for a premium payment or when the policyholder withdraws some or all of the money he has earned.

Cash Value Plans

Many whole life insurance plans, in addition to providing the insured with fixed death benefits, also accumulate cash value as policyholders pay into the plans with their premium dollars. A portion of the premium dollars enter a fund that accumulates interest. It is common, particularly with plans that have been in force for many years, for the cash value to exceed the amount the policyholder has paid in premiums. Therefore, people use this type of life insurance as an investment vehicle along with taking advantage of the protection it provides their families in the event of an untimely death.

While many financial advisers remain steadfast against using life insurance for investment purposes, claiming the returns, historically, have been extremely weak compared to mutual funds and other investments, the fact remains the cash value of most whole life insurance policies grows over time. Because this is considered income to the policyholder, it has income tax implications.

The good news for a whole life policyholder is they do not have to pay income taxes each year on the growth in his plan's cash value. Similar to retirement accounts, such as 401(k) plans and IRAs, the accumulation of cash value on a whole life insurance policy is tax-deferred. Even though this money qualifies as income, the IRS does not require the policyholder to pay taxes on it until he cashes out the policy.

If and when a policyholder elects to take the cash value of his whole life insurance policy, the amount he is required to pay taxes on is the difference between the cash value he receives and the total he paid in premiums during the time the policy was in force. For example, if he pays $100 per month for 20 years, or $24,000, and then cashes out the policy and receives $30,000, the amount subject to taxes is $6,000.

Another feature of whole life insurance is that, in many cases, the policyholder is allowed to take out a loan against the cash value of his policy. There is a misconception that the proceeds from this kind of loan are taxable. That is not the case, even when the loan amount exceeds the total premiums paid into the policy. Taking out a loan simply reduces the cash value of the policy and, if applicable, reduces the death benefit paid.

Life Insurance Premiums Not Tax-Deductible

An additional misconception that is fairly common about life insurance premiums is that they are tax-deductible. Unlike health insurance premiums, which policyholders may deduct from their federal income taxes, life insurance premiums are classified as a personal expense by the IRS. By rule, a taxpayer cannot deduct any money spent on personal expenses, including life insurance, when he files his tax return.