What You Need to Know About Tax Benefits and Life Insurance

iQuanti: Whether you're purchasing a life insurance policy or the beneficiary from someone else's, you may have important questions about what role taxes play. This post will explore which aspects of life insurance are taxable and which aren't. 

Death Benefits are Tax-Free

Most people get life insurance because they want to provide their loved ones with income replacement if they are no longer here to support them, or because they wish to leave a significant windfall to their heirs. Either way, these death benefits are considered tax-free. 

When your beneficiaries receive them, they are not counted as earned income and therefore do not have to be reported on their federal income tax returns. That's a huge advantage because they'll have tax-free money to use for everyday living expenses, paying off the mortgage, or funding major future goals like sending the children to college.

Earnings Do Incur Taxes

While the death benefit from a life insurance policy may not be taxable, any money earned on top of it before the benefit is paid out is considered taxable. This generally includes any interest that may incur while the claim is being validated or if the payouts are broken up over several years.

For example, instead of receiving one lump sum life insurance payment, the beneficiary may take an option offered by the insurance company to distribute it over the next ten years with interest. With each payment that's received, the beneficiary would be responsible for reporting only the interest portion as earned income and paying the applicable tax.

Life Insurance Premiums Are Not Subject to Sales Tax

Like most of your family's regular household expenses, the life insurance premiums are not subject to sales tax. Even though you're buying the policy with post-tax earnings, there will not be an additional state sales tax on top of the price quoted by the insurance company.

Life Insurance Premiums Are Not Tax-Deductible

Unless you're a business owner and can demonstrate that life insurance was purchased as a qualified business expense, the premiums will not be tax deductible. They will be considered personal expenses just like any other cost of living.

As a matter of fact, if you work for an employer who offers more than $50,000 worth of group term life insurance coverage, you may be required to pay taxes on the additional cost of the premiums. This is because the IRS defines coverage above and beyond this limit to be a fringe benefit (i.e., non-monetary compensation), just like a company car.

Cash Value Grows Tax Deferred

If you've decided to buy a permanent life insurance policy, such as whole life or variable universal life, then it will contain a cash value component. Cash value is like a bank account within the policy itself. 

One of the huge benefits of cash value is that it grows tax deferred. This means that if the money stays inside the policy and it's not withdrawn, the policy owner will not owe any taxes on the earnings.

On top of this, if the policy owner wants to borrow against the cash value, they can do so without triggering a tax bill. This is because the money is treated as a loan, not a withdrawal.

The Bottom Line

If you're the beneficiary of someone's policy, the death benefit is generally not considered taxable unless earnings are involved. When you purchase life insurance, it won't be subject to sales tax, but the premiums aren't tax deductible. Consider the tax advantages of policies with cash value since you can borrow against them without triggering a tax bill.