Is Life Insurance Taxable? - Zupnick Associates

(by Jordan Johnson)

You will find life insurance taxable in a few ways. It’s not complicated, but you do want to know them to get the best value for your policy.

Some policies could even help you with your taxes and provide a tax advantage.

Taxable Stages of Life Insurance

First off, the beneficiary won’t have to pay a penny toward taxes on anything they receive. However, there are a few tax implications that the policyholder must take into consideration before the insured passes.

This way the death benefit won’t be taxed before it reaches the beneficiary’s account, including the total value of the insured’s estate.

The Premiums

The first point is the life insurance premiums themselves. The IRS considers life insurance premiums to be personal expenses so, almost all premiums, including prepaid life insurance plans, are subject to federal tax. An exception to this is employer-sponsored plans.

Employer Life Insurance Tax Breaks

Employer-sponsored life insurance can save you quite a bit of money. There are forward-thinking employers who offer coverage to their workforce as part of their compensation package, but there are indirect benefits for employees of organizations who don’t offer life insurance.

Many employers who don’t pay for life insurance outright still provide employees with access to group life insurance plans that offer discounts and a tax break on the first $50,000 of a plan’s death benefit. 

You can always get a plan that provides a death benefit larger than $50,000 and take the cost of $50,000 out proportionally. 

Federal and State Estate Taxes

Another potential taxable step comes after the insured passes. This is because the death benefit is added to the value of the deceased’s estate if they are the owner of the policy when they die. This may put the value of their estate into the taxable range.

If that’s the case, the insured should transfer the policy out of their name at least three years before passing to stop the benefit from being taxed. Another solution is to place the policy in an irrevocable life insurance trust, where trustees will manage the death benefit and pay the premiums. 

Here are some key points to remember about estate taxes:

  • The federal estate tax threshold is currently $12.02 million and typically changes every year. It could potentially go up or down.
  • Some states have their own inheritance tax and estate tax thresholds separate from federal taxes and are typically much lower.
  • The three-year rule means the insured has to transfer the policy out of their name at least three years before they pass or it will still count towards their estate.

How Tax Works in Cash Value Plans

Permanent life insurance policies have two distinctly separate components – the regular death benefit and a cash value element. 

The cash inside these plans are invested and any profits are subject to taxation, although it is deferred until withdrawn. That means you can continue to grow your assets, rebalance them, and only pay tax when you finally withdraw the money.

Variable universal life policies allow the policyholder to choose how the money is invested, making the tax-deferred growth a tangible benefit.

So, aside from saving the headache of adjusting your investments on your tax return each year, your cash assets being in a life insurance plan can also benefit you financially in two key ways:

1. Rebalancing Your Portfolio Is Easier

Your portfolio will grow without being taxed when you rebalance your portfolio. Of course, each investing strategy is different, but having the ability to rebalance your portfolio without paying tax on any profits made is a huge advantage when considering compounding interest.

2. You Can Withdraw Earnings When You Are in a Lower Tax Bracket

The other key consideration is that your plan is designed for you to make payments while you’re young and during            your working life. The interest gained can be used to pay for premiums later in life.

That means you will use your working years to pay into the plan when you are likely to be earning more and in a higher tax bracket. That allows you to withdraw any profits made from investments in your senior years, when you are likely to be paying less income tax, saving you money.

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