Tax Consequences of Owning Life Insurance ; image: clipart family

It is important for life insurance policyholders to consider the tax implication when they buy life insurance.

FEDZONE Ed Zurndorfer
Many federal employees and retirees own life insurance policies. The main purpose of owning life insurance is to pay out a lump sum in the event of the insured’s death, providing financial support to the insured’s beneficiaries and heirs. Since life insurance is intended to support a policyholder’s beneficiaries, the IRS treats it differently from other types of financial products.

It is important for life insurance policyholders to consider the tax implication when they buy life insurance. The IRS imposes different tax rules on different life insurance plans. This column explains some of the tax implications of owning life insurance.

When are Life Insurance Premiums Deductible?

Life insurance premiums paid by an individual (either a term or a permanent life insurance policy) are generally not tax deductible. One exception applies to an individual who is divorced and whose divorce agreement executed before 2019 requires the individual to purchase a life insurance policy, naming the former spouse as beneficiary. In this case, the paid premiums can be deducted as alimony payments.

Prior to the passage of Tax Cuts and Jobs Act of 2017, alimony payments made by the paying spouse were tax deductible (as an adjustment to income). Effective January 1, 2019, alimony was no longer deductible to the paying spouse.

Employer-Paid Life Insurance

When an employer provides life insurance as part of an overall employee benefits package, the IRS considers the employer-paid premiums to be potentially taxable income to the employee. In particular, under IRS rules the taxable portion of the employer-paid premiums applies to more than $50,000 in life insurance coverage. The premium cost paid by the employer for the first $50,000 in coverage is exempt from federal income tax.

An example of employer-paid life insurance coverage is the Federal Employee Group Life Insurance (FEGLI) program in which many federal employees are enrolled. FEGLI’s coverage includes the “Basic Insurance” equal to an employee’s current year SF-50 salary adjusted slightly upward. Employees pay two-thirds of the premium cost and the federal government pays the other one-third of the premium cost. If an employee enrolls in the FEGLI “Basic Insurance” and the employee’s SF-50 salary exceeds $50,000, then the portion of the premiums paid by the federal government are taxable to the employee. The taxable amount appears on an employee’s W2 statement each year in Box 12 (“Cost of Employer-Paid Life Insurance” – Code C) and added to the employee’s Taxable wages (Box 1 of the W2), Social Security wages (Box 3 of the W2) and Medicare wages (Box 5 of the W2).

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The taxable amount of employer-paid life insurance premium is based on IRS tables, regardless of the actual premiums paid. For example, a 70-year-old receiving $100,000 in life insurance coverage is considered to have earned $103 per month in additional compensation, or $1,236 per year.

Prepaid Life Insurance

There are cash-value (permanent) life insurance policies that allow a policyholder to contribute to the policy a lump-sum amount of money to the insurance policy. For example, universal life Insurance policies. The lump-sum payment can be used to pay some or all of insurance plan’s premiums throughout the insurance plan’s duration.

The lump-sum payment grows in value over time because it accrues interest. The IRS considers the interest income to be taxable when the interest income is applied to a premium payment or when the policyholder withdraws some or all of the money earned.

Using Cash Value (Permanent) Life Insurance as An Investment

There are whole life insurance plans which, in addition to providing the insured (usually the policyholder) with a fixed death benefit, accumulate cash value. A portion of the premium dollars enter a fund that accumulates interest. With whole life insurance plans that have been in existence for many years, it is common that the cash value exceeds the amount of premiums paid. Many individuals use this type of life insurance as an investment vehicle. Since the cash value of most whole life insurance policies grows over time, the accumulated cash value is considered income to the policyholder and therefore has income tax implications for the policy owner.

The Tax Consequences of Owning Whole Life Insurance

Whole life insurance policyholders do not have to pay income taxes each year on the growth of the cash value in the policy. Although the accumulation of cash value qualifies as income, the IRS does not require a policyholder to pay income tax on the accumulated cash value until the policyholder cashes out the policy.

When a whole life insurance policyholder elects to withdraw the cash value, the amount of income they are required to income tax on is the difference between the cash value they receive and the total premiums they paid during the time the policy was in force. The following example illustrates:

Peter owns a whole life insurance policy in which he has paid $200 a month for 25 years or a total of $50,000. If Peter cashes out the life insurance policy and receives $70,000, the amount subject to income tax is $70,000 less $50,000, or $20,000.

Taxation of Life Insurance Death Benefits

Lie insurance proceeds that a beneficiary receives are not included in the beneficiary’s income and do not need to be reported as income to the IRS. However, life insurance proceeds may be subject to federal and/or state estate taxes when they are included in the state of the deceased life insurance policyholder.

Employees and retirees who own any type of a life insurance policy and who have questions concerning the income tax and estate tax consequences of owning life insurance are advised to contact a tax professional familiar with the IRS rules concerning life insurance ownership.

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.

Tax Consequences of Owning Life Insurance ; image: clipart family

Tax Consequences of Owning Life Insurance