Term Insurance Comes Under Which Section?

Term insurance provides financial protection for a specific period, offering a death benefit to beneficiaries if the insured passes away within the policy’s term. This insurance helps families maintain financial stability by replacing lost income or covering expenses such as mortgages or education costs. Understanding the tax implications of term insurance, for both premiums paid and benefits received, is important for policyholders and beneficiaries. This article explores how term insurance premiums and death benefits are treated under federal tax law.

Paying for Coverage: Premium Deductibility

For individuals, premiums paid for personal term life insurance policies are generally not tax-deductible. The IRS views these as personal expenses, similar to car insurance or health insurance premiums, that do not qualify for a tax deduction. This rule is outlined in Internal Revenue Code (IRC) Section 264.

There are limited exceptions where life insurance premiums might be deductible, primarily within a business context. Employers can often deduct premiums paid for group-term life insurance provided to employees. This deduction is allowed as a business expense, provided the plan meets IRS requirements.

In contrast, premiums for key-person insurance, purchased by a business on the life of a vital employee to protect against financial loss if that employee dies, are generally not tax-deductible for the business. This is because the business is typically the beneficiary of the policy, and the death benefit received is generally tax-free. The IRS prevents a “double tax benefit” of deducting the premiums and receiving a tax-free payout.

Historically, life insurance premiums paid as part of alimony obligations had different tax treatment. However, for divorce or separation agreements executed after December 31, 2018, alimony payments are no longer deductible by the payer nor taxable to the recipient. Life insurance premiums paid as part of such arrangements follow this non-deductible, non-taxable treatment.

Receiving Benefits: Death Benefit Taxation

Generally, the death benefits paid from a term life insurance policy to a named beneficiary are income tax-free. This exclusion is provided under Internal Revenue Code (IRC) Section 101.

While the principal death benefit is typically tax-free, certain nuances can affect the taxability of proceeds. If beneficiaries choose to leave the death benefit with the insurance company and receive payments over time, any interest earned on the held proceeds becomes taxable income to the beneficiary. Only the interest portion is taxed, not the original death benefit amount.

Another exception is the “transfer-for-value” rule. If a life insurance policy is sold or transferred for valuable consideration, the death benefit may become taxable to the recipient to the extent it exceeds the consideration paid for the policy and any subsequent premiums. This rule aims to prevent the use of life insurance policies as investment vehicles.

Accelerated death benefits, which allow a policyholder to access a portion of their death benefit while still living due to a terminal or chronic illness, are generally treated as tax-free. These payments are excluded from gross income, similar to regular death benefits, provided certain conditions are met.

Special Cases: Business and Estate Considerations

Term insurance can serve specialized roles in business and estate planning, leading to distinct tax considerations beyond personal policies. In a business context, two common applications are key-person insurance and group-term life insurance.

Key-person insurance protects a business from the financial impact of losing a critical employee. The death benefit received by the business is typically income tax-free, provided specific IRS requirements are met.

Group-term life insurance, offered by employers to their employees, presents different tax implications. Premiums paid by the employer for group-term life insurance are generally tax-deductible as a business expense. For employees, the cost of the first $50,000 of coverage provided by the employer is typically excluded from their taxable income. However, if the coverage exceeds $50,000, the imputed cost of the excess coverage is considered taxable income to the employee and must be reported on their W-2 form. This imputed income is subject to Social Security and Medicare taxes.

Regarding estate tax implications, while death benefits from life insurance are generally income tax-free to the beneficiary, the value of the policy can be included in the deceased’s taxable estate for federal estate tax purposes. This occurs if the insured individual owned the policy at the time of their death or if they retained certain “incidents of ownership” over the policy, such as the right to change beneficiaries or cancel the policy. If the total value of the estate, including life insurance proceeds, exceeds the federal estate tax exemption limit, estate taxes may apply.

To remove life insurance proceeds from a taxable estate, individuals sometimes transfer policy ownership to an Irrevocable Life Insurance Trust (ILIT). An ILIT is a specialized trust that owns the policy, removing it from the insured’s direct ownership and taxable estate. This strategy can help reduce potential estate tax liability, but it involves complex legal and tax planning. Once transferred to an ILIT, the insured gives up control over the policy, including the ability to access its cash value or change beneficiaries.