Can You Claim Life Insurance on Tax?

Life insurance serves as a contract between a policyholder and an insurer, where the insurer agrees to pay a designated beneficiary a sum of money upon the death of the insured person. Policyholders typically pay regular premiums to maintain this coverage, which can offer financial security to loved ones by replacing lost income or covering expenses. The tax treatment of life insurance is often complex, varying significantly depending on the type of policy and how it is used. Navigating these rules is important for understanding the true financial impact of a life insurance policy.

Tax Implications of Life Insurance Premiums

Premiums paid for personal life insurance policies are generally not tax-deductible. The Internal Revenue Service (IRS) considers these payments a personal expense, not an income-generating investment or business expense. This applies to both term life and permanent life insurance, which includes a cash value component.

Limited exceptions exist, primarily in business contexts. Businesses providing group-term life insurance for employees may deduct premiums as a business expense. However, if employee coverage exceeds $50,000, the cost above this amount may be taxable income to the employee.

Exceptions also include policies donated to qualified charities, where premiums might be deductible as charitable contributions, subject to limits. Premiums paid for certain alimony arrangements established before 2019 may also be tax-deductible for the payer. These scenarios are not common for the average individual policyholder.

Tax Implications of Life Insurance Death Benefits

The death benefit is typically not subject to federal income tax. Beneficiaries generally receive the full payout without reporting it as gross income. This tax-free treatment applies to various policy types, including term, whole, and universal life insurance, ensuring financial support reaches intended recipients.

Certain situations can lead to a portion of the death benefit becoming taxable. If beneficiaries choose installment payouts, any interest earned on deferred amounts will be subject to income tax. For example, if a $500,000 death benefit is paid over several years with added interest, that interest component is taxable.

The “transfer for value” rule is another exception. It applies when a life insurance policy is transferred for valuable consideration. If transferred for value, a portion of the death benefit exceeding the cost basis (premiums paid plus consideration for transfer) may become taxable to the beneficiary. This rule prevents using policies as investment vehicles for profit through secondary market transactions.

Tax Implications of Cash Value Policies

Permanent life insurance policies, such as whole life and universal life, accumulate a cash value component. Its growth is generally tax-deferred, meaning policyholders do not pay taxes on annual gains as they accrue. This deferral allows the cash value to compound more efficiently, providing a potential financial resource within the policy.

Policyholders can access accumulated cash value through policy loans. Loans against cash value are generally tax-free, considered debt rather than earnings distribution. However, if the policy lapses with an outstanding loan, the loan amount exceeding the policy’s cost basis (total premiums paid) could become taxable income.

Withdrawals from cash value are treated differently than loans for tax purposes. They are generally tax-free up to the cost basis (premiums paid into the policy). Any amount withdrawn exceeding this cost basis is considered a gain and is taxable as ordinary income. This “first-in, first-out” (FIFO) method allows policyholders to recover their original investment tax-free.

When a policy is surrendered, tax implications depend on whether a gain exists. If the cash surrender value received exceeds total premiums paid, the difference is a taxable gain, taxed as ordinary income. Conversely, if the cash surrender value is less than total premiums paid, any loss is generally not tax-deductible.

Dividends from participating life insurance policies are typically treated as a return of premium. They are generally tax-free up to the total premiums paid into the policy. If cumulative dividends received exceed total premiums paid, any excess becomes taxable income. This encourages policyholders to reinvest dividends or use them to reduce future premiums.

Life Insurance in Business

Businesses often use life insurance. Key person insurance, where a business insures a vital employee, is common. Premiums paid by the business for key person insurance are generally not tax-deductible. However, death benefits received by the business upon the insured’s death are typically tax-free, providing funds to offset financial losses from losing a crucial individual.

Life insurance also funds buy-sell agreements. Premiums paid for policies used in these agreements are typically not tax-deductible for the business or individual owners. Death benefits received by surviving owners or the business are generally tax-free, providing liquidity to execute the agreement and purchase the deceased owner’s share.

Employer-provided group-term life insurance has specific tax treatment. Premiums paid by an employer are generally deductible as a business expense. For employees, coverage up to $50,000 is typically tax-free. However, the cost of coverage exceeding $50,000 is considered taxable income to the employee.

Life Insurance and Estate Planning

Life insurance proceeds can be subject to estate tax. If the insured individual owns the policy at death, death benefit proceeds are generally included in their taxable estate for federal estate tax purposes. This inclusion can increase the estate’s value, potentially subjecting it to estate taxes if the total value exceeds the federal estate tax exemption limit. For 2024, this limit is $13.61 million per individual.

To avoid including life insurance proceeds in the taxable estate, an Irrevocable Life Insurance Trust (ILIT) is a common estate planning tool. An ILIT is an irrevocable trust designed to own a life insurance policy. Since the insured does not own the policy within an ILIT, death benefit proceeds are typically excluded from their taxable estate upon death. The trust owns the policy and distributes funds according to its terms.

When premiums are paid on policies owned by an ILIT or another individual, potential gift tax implications may arise. If the insured pays premiums directly to the insurer for an ILIT-owned policy, these payments are considered gifts to the trust beneficiaries. These gifts may be subject to annual gift tax exclusion limits, allowing a certain amount to be gifted without incurring gift tax or using lifetime exemption. Amounts exceeding this exclusion reduce the donor’s lifetime gift tax exemption.