On the laundry list of adult responsibilities, life insurance is usually at the very top. Another top adulting task? Taxes. And if you really want to feel like a supremely responsible adult, you can dig into how life insurance impacts your tax bill at the end of the year.
Specifically, many people hear that life insurance has tax benefits, so they wonder: Is life insurance tax deductible? The answer, for the most part, is no. That said, there are several exceptions that we’ll dig into.
Life insurance provides money to someone you choose if you pass away while the policy is active. It is a contract between you, the owner of the policy, and the insurance company of your choosing, explains Reshell Smith, a Certified Financial Planner with Transition Money Pro and founder of AMES Financial Solutions. “As long as the owner pays the premiums as promised, the insurance company will pay out a lump sum death benefit to the beneficiaries of the policy,” she says.
With a term life insurance policy, you’re covered for a specific time period (or “term”). So, if you have a 20-year term and pass away during that time, your family would receive funds that they could use however they want. This could include day-to-day expenses, covering a funeral, paying off a mortgage or car, funding college tuition or more. If you were to pass away after that term expires, you wouldn’t be covered. There’s another type of life insurance, called whole life, that covers you for your entire life, though it tends to be far more expensive and complicated.
The short answer is no. The premiums you pay each month to secure your life insurance policy are not tax deductible, meaning you can’t write them off on your year-end taxes.
However, there are a few exceptions that are worth noting.
Another exception is if you were to take a withdrawal from the cash value of your whole life insurance policy and gift the funds to someone else. Blaine Thiederman, Certified Financial Planner, Principal Advisor and the Founder of Progress Wealth Management, explains that once you’ve withdrawn all your contributions, all that's left is “growth.” That growth, or the money that was earned on top of what you initially contributed, would be taxable at ordinary tax rates.
There’s also another way to “gift” life insurance to another person—and that’s by transferring ownership of a policy. That makes another person or organization (like a charity) not only the beneficiary, but also the owner. “Typically done with permanent policies, a policy ownership transfer still requires you to keep paying premiums so the policy stays active, much like gifting a policy,” Thiederman explains. This means that the person to whom you transfer ownership can borrow against the cash value of the policy or tap into it in other ways.
If you’re choosing to “gift” your insurance policy to an organization, there are more tax advantages, as this is considered a charitable donation and can significantly reduce your taxable estate, explains Thiederman. “You can deduct any premiums that you pay as part of the donation and even claim a further deduction for some of the policy’s value.”
If you’re considering going this route, he recommends confirming that your chosen charity is a certified 501(c)3 and able to accept your policy as a donation. You should probably also meet with a financial advisor to go over how this works before making a commitment.
Term is the most affordable type of life insurance, so your premium might not be terribly high to begin with. For example, a 30-year-old woman in Texas who’s a non-smoker in excellent health could get $1 million in coverage over a 20-year term for $24.78, according to Fabric’s term life insurance quote. Over the course of a year, that’s $297 in total premium payments. Let’s round up and call it $300.
Let’s say that this woman makes a very good income but isn’t super rich. If she pulled in $100,000 a year, her tax rate would be 24 percent as of 2021. The tax rate on her life insurance contributions, then, would be 24 percent of $300, which comes out to $72. Not nothing, but probably not the difference between whether or not she can pay her rent, given how much she makes. And for folks at the lower end of the income spectrum, their tax rates will be lower, too. (If the woman in this example made an annual paycheck of $40,000 instead, her tax rate would be 12 percent. That means that the theoretical tax savings on her insurance premiums would be only $36, which is less than most Turbotax subscriptions.)
Of course, this would be a more impactful deduction for those with a whole life policy, since those premiums are far more expensive than term life, sometimes as much as five or ten times the cost, or even more.
While life insurance premiums don’t typically have tax advantages, the death benefit is tax free. That means that if you were to pass away, your beneficiary can inherit however much your policy is worth without paying any taxes. The proceeds would not be included in your beneficiary’s gross income or on their tax return.
There are a couple exceptions here, too.
Life insurance is never taxable at ordinary income tax rates. Rather, it is included in your gross estate, which is how much money you have upon your death, explains Thiederman. “If your gross estate is above certain limits, your heirs will owe estate taxes. That is a 40 percent tax rate on every dollar above that limit of $12.06 million in 2022.”
What does this mean? Let’s say you had $15 million in savings before you died, and your life insurance policy was worth $5 million. After your passing, this would get added to your overall estate, bringing the grand total to $20 million. In 2022, your first $12.06 million wouldn’t be taxable; the remaining $7.94 million would be. With a 40 percent tax rate, your expected tax bill would be $3.176 million.
In that example, life insurance contributes to your tax bill because it raises the value of your overall estate. But even a $5 million policy wouldn’t push you into taxable territory unless you already had more than $7 million to your name.
If your life insurance policy is set up in installments (or your beneficiary chooses that kind of payout), they won’t receive a lump sum. Instead, they’ll receive the life insurance benefit in smaller payments over time. During that period, the remaining amount that has yet to be paid out will accrue interest. This interest is taxable. “If a beneficiary chooses to take it out in increments, there will be interest paid as the insurance company invests these funds and pays it out as interest (if the investment does well),” explains Abby Eisenkraft, senior tax professional and CEO of Choice TaxSolutions Inc., in Melville, New York. “The guaranteed payments won't be reduced if it doesn't.” In other words, yes, this interest that’s earned will be taxed, however, the life insurance proceeds themselves are generally not taxable, according to Eisenkraft. Annuities—those payments made in increments—are.
With whole life insurance, there’s a cash value component that you can access should you need it while you are still alive, Rebell says. “This is appealing to many people because the amount gradually increases as the years go on. In essence, it adds an investment component.” If you do take out any portion of this policy while you’re still alive, you have to pay taxes on the amount of interest that policy has earned. For example, say you put $100,000 into your account via your monthly premiums and your cash value comes out to $110,000 because it’s grown over time. If you took out that full amount of your cash value, you would only pay taxes on the $10,000 in earnings.
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Fabric by Gerber Life exists to help young families master their money. Our articles abide by strict editorial standards.
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