Since 2004, September has been designated as “life insurance awareness month: by the nonprofit organization Life Happens (https://lifehappens.org). Life Happens is dedicated to helping consumers take personal financial responsibility through the ownership of life insurance and related products. This is the third of a series of FEDZONE columns during September 2025 to help federal employees understand their need for life insurance and the choices they have in the different types of life insurance policies to meet those needs. This column discusses the tax treatment of life insurance policies.
Income Taxation of Life Insurance Death Proceeds
As stated in Internal Revenue Code (IRC) section 101(a)(1), the death proceeds paid out under a life insurance contract by reason of the insured’s death are excludable from a beneficiary’s taxable income for federal income tax purposes. This means that although there are some exceptions, the income tax treatment of life insurance death proceeds is generally favorable to individual taxpayers. However, the estate tax and gift tax treatment of death proceeds paid out from a life insurance policy is more troublesome and generally requires careful planning in order to minimize any potential estate tax liability and/or gift tax liability.
In order for the life insurance proceeds to be paid out to a beneficiary income tax free, the requirement is that the life insurance proceeds are paid out solely by reason of the death of the insured. In addition, as passed into law as a provision of the Health Insurance Portability and Accountability Act of 1996 (HIPAA), certain qualified accelerated death benefits made on behalf of an insured who is terminally ill and expected to die within one year are income-tax free.
Income Definition of Life Insurance
The income tax exclusion of life insurance death insurance proceeds depends in part on whether the life insurance policy meets the definition of life insurance under Internal Revenue Code (IRC) section 7702. In particular, a life insurance policy will qualify as “life insurance” for federal income tax purposes if it meets either of two tests.
The first test is called the cash accumulation test. This test generally applies to more traditional cash value policies such as whole life or universal life under life policies. Under this test, the policy cash value is limited to the “net single premium” that is needed to fund the policy’s death benefit. The net single premium is calculated by the insurance company using an assumed investment interest rate and certain mortality charges.
The second test is a two-pronged test. Life insurance policies designed to pass the second test must qualify under both a guideline premium requirement and a death benefit requirement. The guideline premium requirement limits the total premiums that can be paid by the policyowner at any given time while the policy is in force. The death benefit requirement is met if the contract’s death benefit exceeds a specified multiple of the policy cash value at all times. This multiple varies according to the insured’s attained age. Universal life and similar cash value life insurance policies will be tested under the second two-pronged-test.
Death Benefit Settlement Payout Options
Death benefit proceeds paid by the insurance company to a designated beneficiary upon the insured’s death may be paid under a variety of settlement option. Some payment settlement options may include an interest component. The interest component of the payment is fully taxable. However, the principal component of the settlement option (consisting of the death benefit proceeds) are always income tax-free.
Common settlement options include the installment option, the life income option, the fixed amount option, and the interest-only option. Note that the component of each payment under a settlement option that is attributable to the death benefit proceeds of the life insurance policy (that is, the face amount of the policy) is nontaxable, while the component of each payment that represents interest on the death benefit proceeds is generally taxable. The portion of the payment that is attributable to the death proceeds is calculated by prorating the face amount of the life insurance policy over the settlement option’s payment period. This is called the excludable portion. Any amount of the payment in excess of the excludable portion represents interest which is fully taxable.
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Group-Term Life Insurance
Internal Revenue Code (IRC) section 79 provides an exclusion for the first $50,000 of group-term life insurance coverage provided under a policy that is provided directly or indirectly by an employer as an employee benefit. An example of a group-term life insurance policy is the Federal Employees Group Life Insurance (FEGLI) in which the federal government is the sponsor of a group term life insurance policy for permanent federal employees. There are two parts to the FEGLI program that federal employees are eligible to enroll. The first part is the Basic Insurance Amount (BIA). The BIA is an employee’s modified SF-50 salary. Employees who are enrolled in the FEGLI BIA pay two-thirds of the premium cost while their agencies pay the other one-third of the premium. The second part of the FEGLI program are optional additional coverages (Option A – Standard; Option B – Multiple of Salary; and Option C – Family Coverage) in which employees pay 100 percent of the premiums with no federal government contribution to the premium cost..
Under IRC section 79, an employer-sponsored group life insurance employee fringe benefit is potentially taxable if the life insurance policy coverage exceeds $50,000 and the policy is provided directly or indirectly by the employer. A group policy is provided directly or indirectly by the employer if the employer pays any portion of the premiums.
Since the federal government pays one-third of the premiums for a federal employee’s FEGLI BIA coverage, the FEGLI program is considered coverage provided directly by an employer and the FEGLI BIA life insurance coverage benefit is potentially a taxable fringe benefit.
How much of an employer-sponsored group life insurance is taxable as an employee fringe benefit? The employer can exclude the cost of up to $50,000 of group-term life insurance coverage from an employee’s taxable compensation. The employer must include in a participating employee’s taxable compensation the employer-paid premium cost of group-term life insurance beyond $50,000 worth of coverage.
Deductibility of Life Insurance Premiums
The general rule is that premium payments for life insurance policies are not deductible for federal income tax purposes. It makes no difference what type of a life insurance policy – an individual policy or a group policy, a term life policy or a permanent cash value life policy – premium payments are not tax deductible.
However, in certain situations life insurance premiums may be deductible because the premiums paid meet the definition of some type of potentially tax-deductible expense. An example is a life insurance policy in which the sole beneficiary is a charitable organization. The policyowner can deduct the premiums paid as a charitable donation. In order for the policyowner to benefit with respect to federal income taxes, the policyowner would have to itemize on his or her federal income taxes (file Schedule A). If the policyowner uses the standard deduction rather than itemizing, then the premiums paid would not be deductible.
In short, there are two important concepts to note when determining the deductibility of a life insurance premium payment. The first is the general rule that life insurance premiums are nondeductible for federal income tax purposes. The second is that a deduction can sometimes be obtained for a life insurance premium if the premium can be properly characterized as some other specific type of deductible expenses under the Internal Revenue Code. This determination will usually require a knowledge of tax law, and therefore the advice of a competent and qualified tax professional should be sought.
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.
Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, 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 we 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.
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Ed Zurndorfer, EA, ATA, CFP®, CLU®, ChFC®, CEBS®, ChFEBC℠: Federal Employee Benefits Expert
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Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, 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 we 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.