Are Life Insurance Premiums Tax Deductible
Uncle Sam considers your monthly premiums a personal expense, so they cant be deducted when calculating your taxable income. And they cant be paid using your Heath Savings Account either. Good try, though!
Face it: Ben was right about the two things that are almost always with us in this world. Whatever your specific tax situation, youll want to talk to somebody who handles this stuff every day. Weve vetted some of the best tax pros in the country and can even recommend a local one close by. Do yourself a favor and work with a competent tax pro.
And what about life insurance? There are a host of options. Weve talked about a ton of them here, but when youre ready to toss your permanent insurance policy and get a term policy, get help from a professional. Be sure to contact the company Dave Ramsey trusts and recommendsZander Insurance.
About the author
Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.
Life Insurance Tax Types
There are certain instances when your life insurance payout is taxable. To protect your policy, below is a list of different life insurance tax types:
- Estate Tax: An estate tax is a tax on your right to transfer property upon your death. Your life insurance proceeds may be taxable if your estate is worth more than the maximum threshold allowed.
- Inheritance Tax: The inheritance tax is a tax placed upon the recipient for any inherited cash payouts, properties, and other assets. Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are currently the only states that enforce this tax.
- Income tax: An income tax is collected by the government for any money earned by citizens throughout the year. Typically, life insurance proceeds are not considered taxable income.
- Generation-Skipping Tax: Similarly to the estate tax, the generation-skipping tax is imposed on any assets that skip a generation. They are only enforced when they exceed the same threshold.
When You Sell A Life Insurance Policy
If you decide to sell a permanent life insurance policy and replace it with term life coverage, youll be doing yourself a big favor. But keep this in mind: The agent or broker selling it on your behalf will take a cut from the amount you receive. And don’t expect to get back the amount you’re covered for when you die . You’ll get back less than that, and if the amount you do receive totals more than all the premiums you’ve paid over the years, the news gets worseyou’ll pay income tax on it! Yikes! Why do Bens words on death and taxes keep sounding like prophecy?
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Calculating Your Inheritance Tax
If you believe your family is likely to owe inheritance tax on your estate after you die, then it is important when taking out life insurance to calculate how much that tax bill might be.
Your life insurance payout is likely to go towards paying for debts, funeral expenses and possibly helping your family get by over the few months after you die. The amount of the payout may not be enough if they also receive a large inheritance tax bill for your estate.
First, if your life insurance policy is in trust then it will be exempt from tax. Secondly, calculate what your estate is worth and see if you will have to pay tax.
The average property price outside of London is almost half of the tax threshold, with London properties being around the same value as the tax threshold. So with this in mind, if you fully own a property then it won’t be too difficult for your other assets to put you in the inheritance tax paying bracket.
If you want to give any gifts away while you are alive they might still be due tax after you die if you gave them away within seven years prior to your death. So just be aware that you won’t necessarily be avoiding tax if you give away some of your assets before you die.
Cashing Out Life Insurance Means Paying Taxes On It
Do you need to change any life insurance taxable if you cash it in? The death benefit will not be subject to income taxes by many beneficiaries. A cash withdrawal may, however, be taxable even if you already have a policy. You are subject to taxable income if you withdraw more of your basis than your gains .
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When Death Benefits Are Taxable
The death benefits paid on life insurance policies can be subject to an estate tax in two situations.
- The whole amount of the death benefit is included in the estate and subject to estate tax if the estate is named as beneficiary.
- The whole amount of the death benefit is included in the estate and subject to estate tax if the deceased both owned and was insured by the policy on their date of death.
Most people name individuals as beneficiaries, so the death benefit doesn’t become part of their estate. The second consideration is usually what causes an estate to owe an estate tax.
Is A Life Insurance Payout Taxable
One of the perks of a life insurance policy is that the death benefit is typically tax-free. Beneficiaries generally dont have to report the payout as income, making it a tax-free lump sum that they can use freely.
That being said, there are exceptions. Although rare, the life insurance payout can be taxable in the following situations:
The insurer issues the death benefit in installments
Instead of a lump sum payout, the life insurance beneficiary might receive the death benefit in installments. If this happens, the insurer typically holds the principal amount in an interest-bearing account and issues a percentage of the death benefit over a set number of years. Although the original death benefit is tax-free, the interest that accumulates is subject to income tax.
The death benefit becomes part of your estate
The federal estate tax exemption limit is $11.7 million, which means if your estates total taxable value is greater than this amount, the IRS levies an estate tax. The bottom line is that if you know your estate wont exceed $11.7 million, you dont need to worry about this tax. Plus, proceeds left to your spouse are typically exempt from estate tax, even if they exceed the federal limit.
The policy involves three different people
The death benefit may be subject to gift tax if different people fill each of the policys three roles:
The insured: The person whose life the policy covers.
The policy owner: The person who buys and/or owns the policy.
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When Your Beneficiary Receives A Gain In Cash Value
If you have cash value life insurance , you have an added cash value account associated with your policy. When the policy holder dies, the full cash value goes back to the insurance company. Obviously, nobody gets taxed when theyre not getting paid.
In some very rare cases, an insurance company will agree to sell a policy that pays out some cash value to the beneficiaries upon your death. If thats your situation, good news! The beneficiaries still wont pay income taxunless the amount they receive exceeds the total amount youve paid into the policy over the years, which is highly doubtful.
Earnings From Investing Or Saving The Payout
Lets say you split up your $300,000 insurance payout and invest half of it in stocks and save the other half in an interest-earning savings account. Any interest you earn must be reported on your tax return. Likewise, if your invested money increases in value from $150,000 to $180,000 and you sell your stock, youll pay taxes on the $30,000 you gained if your taxable income is $78,750 or higher, in most cases. The only part of the insurance payout thats tax-free is the value of the policy on the date of death, according to the IRS.
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How Your Family Can Benefit From Tax
Most of the time your death benefit will be non-taxable which means your beneficiaries can gain the full value of your death benefit. Taxes can be frustrating since they take away some of the money your family is entitled to. The entire amount of a life insurance policy when paid out should be tax-free. Although, this may not be the case based on other investments where the beneficiaries would be expected to pay taxes or be taxed on the estate.
Overall, life insurance can help support your familys living expenses. The money can help them maintain their quality of life and not have to worry about making ends meet. Especially if you are the financial breadwinner, consider how your loss of income would affect your family.
The death benefit can help your family cover the costs of your funeral. Funerals can get incredibly expensive, dont let your family foot the bill. In Canada, the cost of a funeral can range from $5,000 to over $15,000.
The death benefit can also help your family pay off any outstanding debt. Tie up your financial loose ends, so your family wont have to bear the burden.
Beneficiaries Can Be Changed
When you buy an insurance policy, you can designate each beneficiary as either revocable or irrevocable. When beneficiaries are irrevocable, it can be difficult to remove them from policies or change their share without their consent. For revocable beneficiaries, the change process is relatively easy and you dont need permission . For example, with Guardian, a beneficiary change can be done online in a few minutes by going to GuardianLife.com and signing in or registering for an account. Other life insurance companies may require a phone call or ask you to fill out a paper form and send it back. An annual review with your agent or financial professional can be a great time to ensure your beneficiaries are up to date.
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You Qualify For Net Investment Tax
Depending on the amount of interest or investment gains you earn from investing your payout, you may have another tax liability in addition to regular income tax: the net investment income tax. This tax has a rate of 3.8% on certain investment gains, including interest. But this tax is only imposed if your modified adjusted gross income, including interest and investment income, exceeds certain thresholds: $200,000 if youre single, $125,000 if youre married filing separately, or $250,000 if youre married and file a joint return.
When You Surrender Your Permanent Life Insurance Policy
If youve read the last couple of sections, youre probably realizing how much of a rip-off cash value life insurance policies are. In that case, youd be smart to turn in, or surrender, that terrible policy for a less expensive term life insurance policy. What would happen with the money in your cash value account? And more importantly, would it be taxable?
In that situation, youd be given a lump sum from the insurance company, but you wouldnt owe any taxesunless the payout was larger than what youd already paid in. That almost never happens, so neither do the taxes. Yay!
Putting Life Insurance Money In A Trust
When you put your life insurance payout in a trust it is exempt from inheritance tax because it’s separate from your estate.
This trust is managed by trustees, who will be chosen by you. This can be a solicitor or family members. They can then distribute the money according to your wishes.
You may also want to write your life insurance policy in trust for a child in your family, who will only be able to access the money once they reach adulthood.
If you plan your taxes accordingly, you could even arrange for your life insurance payout to help pay the tax bill on your estate after you die. For example, if the value of your estate is above the inheritance tax threshold, your family will have to pay tax on that amount. Your life insurance payout will be exempt from tax and could be used to cover the tax bill on the estate.
If your finances are quite complicated then it is best you speak to an independent financial adviser to help you find a solution that works for you regarding taxes and your estate.
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Transfer Of Policy Is Partially Taxable
If you pay cash or other compensation to have a policy transferred to you , youll likely have to pay federal income tax on the portion of the policy value that exceeds the amount you pay for the transfer . For example, if youve paid $5,000 to take possession of a policy with a $45,000 death benefit, and didnt pay any premiums or other qualifying amounts, youll probably have to pay tax on $40,000.
Whats the difference between term life and whole life insurance?
Term life and whole life vary in many ways. A major difference is that term insurance provides coverage for a set amount of time. If you die during the term, the policy pays a death benefit. Whole life is for your entire lifetime and pays whenever you die.
The Reality Is That Life Insurance Is Treated As An Asset In Your Estate And If The Payout Pushes Your Estate Past Federal Or State Estate Tax Exclusion Limits It Could Trigger A Hefty Estate Tax Bill If This Is A Concern You May Want To Consider An Irrevocable Life Insurance Trust
You may think that life insurance is tax-free. Unfortunately, the no tax on life insurance idea is only partly true: Life insurance is income tax-free. In other words, recipients of a decedents life insurance policy do not have to pay income tax on that sum.
However, if its large enough, the decedents estate including any life insurance proceeds could be subject to federal and/or state estate taxes. As an example, let’s say you have a $1 million life insurance policy. The IRS deems that policy an asset, just as if you had an investment portfolio worth $1 million. And upon your death, the IRS sees it as a million-dollar asset you just transferred to your beneficiaries, and taxes it accordingly. That estate tax is usually due upon death, and it can be substantial.
If youre among those wealthy enough to be concerned about this possibility, how can you avoid having your life insurance proceeds included in your estate and therefore possibly subject to the estate tax? You can create an irrevocable life insurance trust and name that trust the owner of your life insurance. By doing so, that particular asset will be removed from your estate. Upon your death, the proceeds from your life insurance will pass on to your heirs not only income tax-free but estate tax-free as well.
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Life Insurance Distributions Following Death
Life insurance distributions following the death of someone else are not taxed.
- If a beneficiary receives a distribution from your life insurance plan upon your death, he does not have to pay income tax on it.
- You can request that the beneficiary use some these funds to help cover your end-of-life expenses, such as your funeral, or you can allow him to use the funds as he desires.
Do I Pay Taxes On An Invested Insurance Payout And The Accumulated Interest
Yes, when you get the payout. Earnings on the payout of life insurance are subject to income tax on earned interest, dividends and realized capital gains on those invested monies, unless theyre invested into another tax-sheltered plan such as a tax-free savings account, says Wouters. The insurance company handles investment decisions beyond the costs needed to provide pure coverage and administrative fees for permanent life insurance policies . The policy may have growing guaranteed cash values and additional non-guaranteed cash values that depend on factors including claims experience, operational costs, long-term interest rates and investment performance, says Wouters.
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Tax Consequences Of Surrendering Your Life Insurance Policy
If you decided to surrender your life insurance policy or were unable to get a life insurance settlement, the policyâs cash value would determine whether you had to pay any taxes. You wouldnât owe any taxes if the life insurance policyâs cash surrender value was less than the amount you had already paid in premiums. However, if the cash surrender value was greater than the amount paid in premiums, the difference would be taxable as income.
Since term life insurance policies donât have a cash value, there would be no taxes associated with surrendering the policy. However, you wouldnât be receiving any money from the insurer either.