Income Taxation of Life Insurance

Estate, Gift, and Generation-Skipping Transfer (GST) Taxation and Life Insurance: Estate Planning
April 6, 2017
Income Taxation of Life Insurance Benefits
April 6, 2017

Income Taxation of Life Insurance

What is life insurance?

Webster’s dictionary defines life insurance as “insurance providing for payment of a stipulated sum to a designated beneficiary upon death of the insured.” However, the tax code has its own extremely complex definition of life insurance. If your life insurance policy qualifies under the tax code, an abundance of income tax advantages may be yours.

There are also estate, gift, and generation-skipping transfer tax consequences to life insurance.

How is life insurance treated for income tax purposes?

Living benefits

Living benefits refer to amounts received under the policy before the insured’s death. They include withdrawals, surrender, loans, and dividends. They are generally treated as tax free to the extent that they don’t exceed your basis in the policy.

Death benefits

Death benefits are received by your beneficiary(ies) after your death (or by you before your death, if the death benefits are qualified accelerated death benefits). See Riders. Death benefits are generally not included in income.

“Inside buildup”

Inside buildup refers to income earned on the premiums (or, more specifically, the part of the premiums that does not cover mortality and administration costs) you pay on the policy, or, in other words, the cash value increase in the policy. As long as the inside cash buildup is not distributed, it is not subject to income tax.

Elections to make policies paid up

You can apply the increase in the cash value of your policy towards premiums you may still owe. This is called electing to make the policy paid up. Since you do not actually receive the cash value, it is not taxable.

Exchanges of life insurance policies

Under Code Sec.1035, life insurance policies on the same insured can be exchanged free of income tax, subject to certain limitations.

Government life policies

Government life policies, or National Service Life Insurance, enjoy a multitude of tax benefits:

  • The increase in cash value is not taxable
  • Income distributed if the policy is surrendered is not taxable
  • Dividends are tax exempt
  • Interest on dividends are tax exempt

Interest on dividends

Dividends are sometimes earned on life insurance policies. They can be distributed or they can remain with the policy. Dividends left with the insurer earn interest. Interest earned on policy dividends is taxable as ordinary income. Dividends are usually comprised of refunds of your premium payments and are not taxable. Dividends in excess of premium payments are taxable as ordinary income. Dividends issued by mutual life insurance companies are not eligible for capital gains tax treatment.

Gain on the surrender of a cash value policy

If you surrender your policy to the life insurance company, any gain realized is taxable as ordinary income to the extend the cash surrender value exceeds the net premium cost. The net premium cost is the total premiums you paid less any tax-free distributions you received. However, if the cash surrender value is less than the net premium cost, you are generally not allowed to deduct the loss.

A policy that is surrendered with an outstanding loan may result in taxable income on the borrowed amount to the extend the cash value exceeds your basis in the contract.

Gain on the sale of a cash value policy

If you sell your life insurance policy with a cash surrender value, gain on the sale of the policy may be taxed partly as ordinary income and partly as long-term capital gain. The gain is the difference between the purchase price and the net premium cost (the tax basis). The net premium cost is the total premiums you paid less any tax-free distributions received, further reduced by the cost of insurance protection that was provided to you up to the time you sold the policy. Your basis is then recovered tax-free. The amount received in excess of your basis (not reduced by the cost of insurance protection) up to the cash surrender value is treated as ordinary income. Any additional amount of gain is treated as long-term capital gain, presuming you owned the policy for longer than one year prior to its sale.

Jim owns a permanent life insurance policy which he purchased ten years ago. He has paid $60,000 in premiums, the policy has a cash surrender value of $78,000, and the cost of insurance protection for the past ten years totals $10,000. Jim now sells the policy to a third party for $80,000. The gain is calculated as follows: $80,000 – ($60,000 – $10,000) = $30,000. That portion of the gain which represents the difference between Jim’s net premium cost and the cash surrender value is taxed as ordinary income, or $78,000 – $60,000 = $18,000. The balance of the gain ($12,000) is taxed as capital gain.

Generally, no loss deduction is allowed.

A policy that is sold with an outstanding loan may result in taxable income on the borrowed amount to the extend the cash value exceeds your basis in the contract.

Gain on the sale of a term policy

If you sell a term policy that you have owned for more than one year, the gain is generally taxed as long-term capital gain. The gain is equal to the excess of the purchase price over the net premium cost (generally, your premiums paid) reduced by the cost of insurance protection. In most instances, the cost of the insurance protection will equal the premiums you pay up to the date of sale. Premium payments made beyond the date of sale (e.g., you pay premiums on the first of each month and the date of sale is in the middle of the month) will equal your basis.

How are premiums paid for life insurance treated for income tax purposes?

Interest earned on prepaid premiums

You may pay your policy premiums before they are due. In this case, any interest earned on the advance payments is taxable.

Premiums in general

The general rule is that premiums you pay on personally owned life insurance policies are not deductible from your gross income as a personal expense.

Premiums constituting alimony payments

An exception to the general rule is if the premiums constitute alimony payments. Where you have made premium payments under a divorce or separation agreement, the payments are taxable as alimony to the non-insured spouse owner of the policy.

Premiums paid on certain policies assigned to charity

Another exception to the general rule is if you are paying premiums on certain policies assigned to charity. To qualify, the assignment must be:

  • Irrevocable, and
  • You cannot reserve the right to surrender the policy

Premiums paid by employers on group term policies

Premiums paid by an employer for a group term life policy are tax-free income to you, the employee. Also, your employer can deduct the premium payments from the company’s income.

However, if the group plan is discriminatory, or the amount of the coverage exceeds $50,000, employees may have to include all or a portion of the premiums in income.

  • Discriminatory plans–If the plan is discriminatory, each key employee must include the greater of the actual cost of the insurance or the cost determined under applicable IRS tables.
  • Plans where coverage exceeds $50,000–If your coverage under the group plan exceeds $50,000, you are taxed on the cost of coverage over $50,000 minus the amount you paid

The $50,000 limitation does not apply to former employees who were terminated and have become permanently disabled, were terminated and attained age 55 before January 2, 1984, or who retired before January 2, 1984.

However, if the group term policy covers the employee’s spouse or children, the cost is included in the employee’s gross income unless the face value amount of the policy is $2,000 or less.

“Cost” is computed by your employer using IRS Table I and is reported on your W-2.

Premiums paid by employers on individual or group permanent policies

Premiums paid by an employer on an individual (as opposed to group) policy on your (the employee’s) life is taxable income to you, unless the beneficiary of the policy is your employer. Premiums paid by an employer for a group permanent policy is also includable in your gross income for income tax purposes.