Is Supplemental Life Insurance Pre-Tax?

Supplemental life insurance offers additional financial protection beyond basic coverage, available through an employer or purchased independently. This coverage provides extra security for beneficiaries in the event of the insured’s death. This article clarifies the tax rules surrounding premiums paid for supplemental life insurance and the benefits received from these policies.

Tax Treatment of Supplemental Life Insurance Premiums

Premiums paid for supplemental life insurance by individuals are not tax-deductible. The Internal Revenue Service (IRS) considers these payments personal expenses. Individuals pay for this coverage with after-tax income, and these premiums do not reduce their taxable income.

When supplemental group life insurance is offered through an employer, tax treatment differs. Internal Revenue Code Section 79 allows an exclusion from income for the cost of employer-provided group-term life insurance coverage up to $50,000. Premiums paid by the employer for the first $50,000 of coverage are not taxable income to the employee.

If employer-provided group-term life insurance coverage exceeds $50,000, the cost above this threshold is “imputed income” to the employee. This imputed income is taxable and included in the employee’s gross income, subject to Social Security and Medicare taxes. The amount is calculated using IRS-provided Uniform Premium Table I rates, which vary by employee age. Employers report this amount on the employee’s Form W-2.

While some employee benefits can be paid pre-tax through a cafeteria plan (Section 125 plan), life insurance premiums for coverage exceeding $50,000 are not eligible for pre-tax treatment. If life insurance is offered through a cafeteria plan, any employee-paid portion for coverage above the $50,000 exclusion is paid on an after-tax basis. This avoids additional imputed income, as pre-tax dollars used for supplemental coverage are considered employer contributions and factored into the imputed income calculation.

For self-employed individuals or business owners, premiums for their own supplemental life insurance are not deductible. These are personal expenses and do not qualify for a tax deduction. Businesses may deduct premiums for group term life policies provided to employees under specific conditions, but not if the business is a direct or indirect beneficiary.

Tax Treatment of Supplemental Life Insurance Benefits

Death benefits paid to beneficiaries from a supplemental life insurance policy are received income tax-free. Under Internal Revenue Code Section 101, amounts received under a life insurance contract by reason of the insured’s death are excluded from gross income for federal income tax purposes. This exclusion applies regardless of the beneficiary’s relationship to the insured.

Policyholders may access accelerated death benefits if they face a terminal or chronic illness. These benefits, called living benefits, are excludable from gross income if certain conditions outlined in Internal Revenue Code Section 101 are met. For instance, if the insured is certified as terminally ill with a life expectancy of 24 months or less, or chronically ill and unable to perform daily living activities, the benefits are received tax-free.

For supplemental policies that accumulate cash value, such as whole life or universal life riders, the cash value grows on a tax-deferred basis. Taxes on accumulated earnings are not due as they accrue, but are postponed until funds are withdrawn or the policy is surrendered. This tax-deferred growth allows the cash value to compound more efficiently over time.

Policy loans taken against the cash value of a life insurance policy are not treated as taxable income, provided the policy remains in force. If the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding premiums paid may become taxable income. Withdrawals from cash value policies are tax-free up to the amount of premiums paid, considered a return of principal. Any amount withdrawn exceeding the cost basis (total premiums paid) is taxable as ordinary income.

If a supplemental life insurance policy with a cash value component is surrendered, any amount received above the total premiums paid (the cost basis) is taxable as ordinary income. The gain is calculated as the difference between the surrender value and the total premiums paid. Surrender charges may also reduce the cash payout received upon surrender.

Key Distinctions and Other Tax Considerations for Supplemental Life Insurance

The tax treatment of supplemental life insurance varies significantly depending on whether it is part of an employer’s group plan or an individually purchased policy. For employer-provided group supplemental policies, premiums for coverage exceeding $50,000 result in imputed income to the employee. In contrast, premiums for supplemental policies purchased directly by an individual are paid with after-tax dollars and are not tax-deductible. This distinction means employer-sponsored group plans can introduce taxable income for higher coverage amounts, whereas individually purchased policies do not offer a tax deduction for premiums.

Life insurance proceeds can have estate tax implications, particularly for larger estates. If the policyholder retains “incidents of ownership” over the policy at death, such as the right to change beneficiaries or borrow against cash value, the death benefit may be included in their taxable estate. Proceeds exceeding the federal estate tax exemption amount ($12.92 million for 2023, scheduled to revert to $5 million indexed for inflation after 2025) can be subject to federal estate tax, which can be as high as 40%. Irrevocable life insurance trusts (ILITs) are used in estate planning to remove policy proceeds from the taxable estate by transferring ownership to the trust, avoiding incidents of ownership.

Gift tax considerations arise if a life insurance policy is transferred to another individual or if premiums are paid for a policy owned by someone else. Transferring ownership of a permanent life insurance policy is a taxable gift, with its value determined at the time of transfer. Subsequent premium payments for a policy owned by another person are also considered gifts. The annual gift tax exclusion ($19,000 per recipient in 2025) helps reduce or eliminate gift tax liability for such transfers and payments.

While federal tax rules are consistent across the United States, state income or estate tax laws can apply to life insurance. Some states may impose their own estate or inheritance taxes, which could affect life insurance proceeds. Consider these state-specific nuances in addition to federal tax regulations.