It's important to consider the tax implications when you're 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 coverage of $50,000 or more are 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. 

First Considerations

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.

If you are only concerned with covering your own burial and funeral costs for your next of kin, you may opt for a death benefit of $20,000 or less. By contrast, if you have several dependent children, all of whom you hope to send to college in the future, you would probably want $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 you, as the policyholder, are quoted when you obtain coverage is the amount you pay, 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 an employer provides life insurance as part of an overall compensation package, 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.

If, for example, an employer provides an employee, for the duration of their employment, with $50,000 in life insurance coverage in addition to their salary, health benefits, and retirement savings plan, the employee doesn't have to pay taxes on the life insurance benefit because it does not exceed the threshold set by the IRS.

Alternatively, if the employer-provided life insurance coverage is for $100,000, the employee has to pay taxes on part of it. The premium dollars that pay for the $50,000 in coverage they receive 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 they have earned.

Life insurance premiums, which are classified as a personal expense by the IRS, cannot be deducted on your federal tax return.

Cash Value Plans

Many whole life insurance plans, in addition to providing the insured with a fixed death benefit, 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. 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.

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. Nonetheless, the fact remains that 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 tax consequences

The good news for a whole life policyholder is they don't have to pay income taxes each year on the growth in their 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 a policyholder to pay taxes on it until they cash out the policy.

If and when a policyholder elects to take the cash value of their whole life insurance policy, the amount they are required to pay taxes on is the difference between the cash value they receive and the total they paid in premiums during the time the policy was in force. If, for example, they pay $100 per month for 20 years, or $24,000, and then cash out the policy and receive $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 the 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 out.