The month of September has been designated by the Life Insurance and Market Research Association (LIMRA) as “Life Insurance Awareness Month.” Since many federal employees have a need for life insurance, the FEDZONE is presenting a series of columns this month discussing issues associated with life insurance. Previous columns discussed individual and group life insurance, term life insurance, and cash value (permanent) life insurance. This column discusses the tax treatment of life insurance.
The taxation of life insurance is in fact a complex subject. There are a variety of pitfalls for the unwary.
The premiums paid on individual life insurance policies – whether the policy is an individual policy bought by an individual from a private insurance company or a group life insurance policy such as the Federal Employees Group Life Insurance (FEGLI) – are generally not deductible for federal income tax purposes. This is because life insurance premiums are considered a personal expense.
There are some exceptions. In some situations, life insurance premiums may result in tax savings. For example, if a charity (church, mosque, synagogue, the Goodwill, etc.) is named as the exclusive beneficiary of an individual life insurance policy, then the premiums paid may be deductible on one’s federal income tax return as a charitable contribution if the individual itemizes. Another example would in the case of an individual who is required to own a life insurance policy on himself or herself and who is paying alimony to a former spouse as part of a pre-January 1, 2019 divorce settlement. The former spouse is the named life insurance policy beneficiary. The premiums paid would be considered as alimony and deductible as an adjustment to income on the individual’s federal income tax return.
Employer-Sponsored and Subsidized Group Life Insurance
With respect to employer-sponsored and subsidized group term life insurance such as FEGLI, an employer – in this case, the Federal government which sponsors FEGLI – may provide its employees with up to $50,000 of group term life insurance without any tax consequences to its employees. The taxable value of group term insurance in excess of the $50,000 exclusion amount is determined using an IRS table shown below.
Federal employees enrolled in FEGLI pay two-thirds (2/3) of the premium cost of their “Basic Insurance Amount” (BIA). The BIA is an employee’s current SF-50 salary rounded up to the next $1,000 plus $2,000. This means that an employee whose current SF-50 salary is $97,500 has $98,000 plus $2,000 or $100,000 of FEGLI BIA coverage. The federal government pays one-third (1/3) of the BIA premium cost. Employees pay the entire premium cost of each of the optional coverages (Option A – Standard, Option B – Multiples of Salary; and Option C (Family Coverage). Therefore, there are no tax implications for employees with respect to the FEGLI optional coverages
However, for the FEGLI BIA, a federal employee who has BIA in excess of $50,000 likely has taxable income as a result of the federal government paying one-third of the BIA premiums. The steps for determining if the amount of FEGLI BIA premiums that are taxable to an employee are as follows:
- Find the amount of the employee’s FEGLI BIA that is potentially taxable; that is, the amount BIA in excess of $50,000, in each calendar month of the calendar year*.
- Subtract $50,000 from each month’s coverage
- From the balance in #2 if any, for each month apply the uppermost age cost from the table below
- From the sum of the monthly cost, subtract the employee’s total premiums paid annually. The result is the amount taxable.
*If an employee’s FEGLI BIA changes in the middle of a month, then take the average of the FEGLI BIA at the beginning and at the end of the month.
Cost Per Month of Group Term Life Insurance as Determined on the…
Basis of Uniform Premiums Prescribed by the IRS*
| Age | Cost |
| Under 25 | $0.05 |
| 25 through 29 | 0.06 |
| 30 through 34 | 0.08 |
| 35 through 39 | 0.09 |
| 40 through 44 | 0.10 |
| 45 through 49 | 0.15 |
| 50 through 54 | 0.23 |
| 55 through 59 | 0.43 |
| 60 through 64 | 0.66 |
| 65 through 69 | 1.27 |
| 70 and older | 2.06 |
Two examples help illustrate:
Example 1. Jill, age 55, is a federal employee who has an SF-50 salary during 2020 of $51,350. Kill has a BIA of $52,000 + $2,000, or $54,000. That is, the $51,350 rounded to the next $1,000 plus $2,000.
Total group-term life insurance $54,000
Less: Amount excludable ($50,000)
Potentially taxable coverage $4,
Monthly cost per $1,000 (see table) $0.43
Annual cost per $1,000 (12 x $0.43) $5.16
Cost of taxable insurance ($5.16 x 4) $20.64
Less Jill’s FEGLI premium contributions)
($0.15/$1,000 per pay period x 26 pay periods
X 54) ($210.60)
Amount of Jill’s FEGLI premiums that are taxable $0.00
Example 2. William, age 62, has $108,000 of FEGLI BIA during 2020
Total group-term life insurance $108,000
Less: Amount excludable ($50,000)
Potentially taxable coverage $58,000
Monthly cost per $1,000 (12 x $0.66) $7.92
Annual cost per $1,000 (12 x $7.92) $95.04
Cost of taxable insurance ($95.04 x 58) $5,512.32
Less William’s FEGLI premium contributions
($0.15/$1,000 per pay period x 26 pay periods
X 108) ($421.20)
Amount of William’s premiums that are taxable $5,091.12
Note: The $5,091.12 of taxable income will be added to William’s 2020 W-2 Box 1 (taxable wages), Box 3 (Social Security wages), and Box 5 (Medicare wages).
Death Benefit Paid in Installments
Instead of a lump-sum payout, the life insurance beneficiary may receive the death benefit in installments. If this happens, the insurance company typically holds the principal amount in an interest-bearing account and pays a percentage of the death benefit over a set number of years. Although the original death benefit (that is, the face amount of the life insurance policy) is tax-free, the interest that accumulates is subject to federal and state income tax in the year it is received by the beneficiary.
What are the Tax Ramifications of Cash Value Life Insurance Policies?
Whole life, universal life, variable life, and other permanent life insurance policies accumulate cash value which the policy owner can withdraw or borrow against as long as the policy is active.
The cash value in a permanent life insurance policy for the most part is tax-deferred. This means that the policy owner will only pay income tax on the cash value if the policy owner accesses it. But the IRS will levy a tax only on the amount of cash value that exceeds the policy “cost basis”. The policy “cost basis” is equal to what the policy owner has paid cumulatively in premiums minus any dividends received. In short, if the policy owner withdraws less than the policy “cost basis”, the cash value is tax-free. Any withdrawals over the policy “cost basis” are subject to federal and state income taxes.
In the event a cash value life insurance policy owner pays significantly more than the minimum required amount of life insurance policy premiums, the IRS may classify the life insurance policy as a modified endowment contract or MEC. The result of having a MEC is that the IRS taxes cash value withdrawals as income first, even when the withdrawn amounts are less than the policy “cost basis”. Anyone who owns a permanent life insurance policy and suspects that the insurance policy has a MEC status is strongly advised to consult with a tax professional.
There are three situations in which accessing the cash value of a permanent life insurance policy that exceeds the policy “cost basis” can result in a considerable tax bill. These three situations are:
- Surrendering the policy. When a permanent life insurance policy is surrendered, the life insurance coverage is canceled and the insurance policy pays out the policy’s cash value minus any surrender fees. The portion of the cash value that exceeds the policy “cost basis” is taxable. For example, if a cash value life insurance policy whose cash value is $20,000 is surrendered and the policy “cost basis” is $10,000, then the IRS considers the additional $10,000 as income and taxes it accordingly.
- Selling the policy. Selling a permanent life insurance policy – often called a “life settlement” – can result in the policy owner receiving more money compared to surrendering a permanent life insurance policy. This is because the policy’s sales price is not capped at the cash value amount but rather based on a variety of factors such as the policy owner’s life expectancy, the death benefit, and the premium cost.
The IRS levies two types of taxes on the sale of a permanent life insurance policy, namely:
- Ordinary income tax: imposed on any sales proceeds that exceed the policy “cost basis”; and
- Capital gains tax: imposed on any proceeds that exceed the policy’s cash value.
An alternative to selling a permanent life insurance policy is to purchase another permanent life insurance policy as part of a “1035 exchange.” This is a provision of the U.S. tax code that allows the policy-owner to exchange similar properties without paying capital gains tax.
· Taking out a loan against the cash value. Cash value loans are tax-deferred, even if the policy owner borrows more than the policy “cost basis’. This means that a policy owner can borrow a large amount of money – tax-free- provided that the policy owner repays the loan. But if the loan is not repaid, the tax implications can be severe. The following example illustrates.
Carl owns a permanent life insurance policy which has $20,000 in cash value. The policy “cost basis” is $18,000. Carl takes out a $30,000 loan. Carl does not have to pay taxes on the additional $10,000 ($30,000 less $20,000) as long as the policy is active. Note, however, as the loan accrues interest, the amount that Carl owes can become greater than the cash value. At this point, the policy owner must repay the loan or the insurance company can cancel the policy.
If the insurance company cancels the policy, it typically uses the cash value to repay the loan. The policy owner will then pay tax on the loan amount that exceeds the policy “cash basis”. In Carl’s case, the “cost basis” is $18,000. In other words, if Carl struggles to pay off the loan and cannot, he will be subject to a large tax bill.
If Carl were to die before paying off the loan, any amount of the loan he owes at the time of his death will be subtracted from the policy death benefit. This means his beneficiaries will receive less of a death benefit.
Life Insurance Dividends
A policy owner does not have to pay taxes on life insurance dividends because the IRS considers these particular dividends as refunds of premiums. But if the insurance company places the dividends in an interest-bearing account, the interest paid on the dividends subject to income tax. Similarly, if more dividends are received than what was paid in premiums, the difference between the total dividends received and total premiums paid is taxable income to the policy owner.
Life Insurance and Estate Taxes
During 2020, the federal estate tax exemption is $11.58 million per individual. This means that if an individual dies during 2020 and the value of the individual’s gross estate is over $11.58 million, the estate is potentially subject to the federal estate tax. If the estate’s gross value is less than $11.58 million, then the estate is not subject to the federal estate tax. If the individual is married, then anything remaining in the individual’s estate that is transferred or left to the surviving spouse is exempt from the federal estate tax, even if the amount received by the spouse exceeds the federal estate tax exemption.
It should be noted if an individual owns a life insurance policy and the individual dies while the life insurance is in force, then while the life insurance gross proceeds are not taxable income to the beneficiary, the life insurance proceeds are included in the individual’s (the policy owner’s) gross estate. The result is that if an individual already has a sizeable estate (real estate, investments, and retirement plans including IRAs) then the life insurance proceeds could push an individual over the federal estate tax exemption.
In addition to the federal estate tax, some states levy their own estate or inheritance taxes. Exemption limits vary among states. For example, Oregon’s estate tax kicks in after $1 million, while New York’s kicks in after $5.74 million. Individuals worried about how their life insurance policy could potentially affect their estate and inheritance tax liability should talk to an estate attorney in their state.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Neither Raymond James, the Financial Advisors, STWS, nor Mr. Zurndorfer are affiliated with, endorsed by, or authorized to speak on behalf of the U.S. Government, the Federal Employee Retirement System, or any other Federal Government-sponsored benefits programs or retirement plans.
These policies have exclusions and/or limitations. The cost and availability of life insurance depend on factors such as age, health and the type and amount of insurance purchased. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Guarantees are based on the claims paying ability of the insurance company.
Variable life insurance is only appropriate for individuals with specific life insurance protection needs. Substantial fees, expenses, and tax implications generally make variable life insurance unsuitable as a short-term savings vehicle. You will be required to pay a certain amount of premiums or maintain sufficient cash value to cover your policy’s fees and expenses. Loans or poor investment performance may also lower your cash value. Failure to maintain sufficient cash value may cause your policy to lapse and terminate. Variable life insurance involves investment risks, just like mutual funds do. If the investment options you selected for your policy perform poorly, you could lose money, including your initial investment. The prospectus does not describe the amount of insurance you purchased and the amount of fees you will pay. Therefore, you should also review any additional materials provided to you when you purchase your policy.
The federal tax rules that apply to variable life insurance can be complicated. In addition, there may be state tax implications. Before investing, you may want to consult a tax adviser about the tax consequences of investing in variable life insurance.