It’s smart to look for every legal tax deduction you qualify for. Whenever you pay an expense, a tax deduction can reduce the impact on your budget. But the tax treatment on life insurance can be confusing. Death benefits are often tax-free, while premiums are typically paid with after-tax funds.
For most individuals and families, there’s no deduction for life insurance premiums. But in certain situations, such as charitable giving or paying employee benefits, premiums might be deductible.
How Life Insurance Works
A life insurance policy pays out a death benefit—typically as a large lump sum—when an insured person dies. You can buy life insurance on yourself, household family members, or anybody else you have a financial interest in. You can also name a beneficiary (or multiple beneficiaries) as the person or entity that receives the death benefit.
To keep a life insurance policy in force, you must pay the insurance company. Those payments, known as premiums, compensate the insurer for taking the risk of a large payout after the insured’s death. You might pay those premiums monthly, quarterly, or annually.
A classic use for life insurance is to insure against the death of a family member—in the case of lost income, for example, or to pay medical bills and final expenses. But businesses, including self-employed individuals, can also use life insurance. When an owner or key employee dies, life insurance can enable a smooth ownership transition.
Some policies include an investment component, often known as the cash value. With these policies, it may be possible to withdraw funds from the account, borrow against the cash value, or cash out the policy entirely. However, any of those actions can reduce your benefits or create tax liabilities.
When Is Life Insurance Tax-Deductible?
For most people who use life insurance for family protection, life insurance premiums are not tax-deductible. Those payments are like many other household expenses that you pay with after-tax dollars. However, beneficiaries typically receive a tax-free death benefit.
That said, life insurance premiums are deductible in several situations.
Tax rules are complicated, and they change frequently. Get advice from a CPA before you make any decisions or attempt to claim a deduction on your return.
When an employer provides life insurance as part of an employee benefits package, those premiums might be a deductible business expense for the employer. However, the rules are complicated. For example, if your business is a direct (or indirect) beneficiary of the policy, the premiums are generally not deductible.
If you transfer ownership of a policy to a qualifying charitable organization, you might receive a tax benefit. The policy’s cash value can provide a deduction, and any premiums you pay after completing the transfer may also be tax-deductible.
There may be other opportunities to deduct life insurance premiums. That’s why it’s critical to speak with a CPA who is familiar with your circumstances and your tax return. As just one example, some divorce agreements executed before 2019 may enable you to deduct premiums you pay to protect an ex-spouse. But the rules are complicated, so it’s smart to get professional advice.
Are Life Insurance Benefits Always Tax-Free?
Death benefits from a life insurance policy are generally not taxable for beneficiaries, but other payments from a life insurance policy can create tax consequences.
For example, if you leave the proceeds of a death benefit with the insurance company, the company may pay interest on your balance, which would be taxable. Some people take that route when deciding what to do with the money. Alternatively, you might set up periodic payments from an insurance company to replace the deceased’s monthly income. Such payments would also generate taxable interest.
Any interest you earn on a death benefit is typically taxable.
Withdrawals and Policy Loans
Some permanent life insurance policies allow you to withdraw funds from any cash value in a policy you own. When you do so, withdrawals that exceed your basis in the policy may be treated as taxable. Similarly, if you “surrender” or cash out the entire policy, you may owe income taxes if you have any gain in the contract. Put another way, if you get out more than you put in, you should expect to pay taxes on that amount.
Taking out policy loans can also lead to taxation, especially if your policy lapses after you borrow against it.
Taxation on life insurance policies is extremely complicated, and there are even more ways to generate a tax liability. For most families using life insurance to protect themselves against an untimely death, those situations are unlikely.
If you’re thinking of selling, transferring, or changing a life insurance policy in any way, it’s critical to speak with your CPA and your insurance agent first.
The Bottom Line
Life insurance can ease the financial burden that often comes with death. It allows you to provide for loved ones after an unexpected loss or facilitate a smooth transition when key employees die.
For most people, the tax treatment of life insurance is one of the least-important aspects. The tax-free nature of death benefits is a welcome feature, but if you buy life insurance primarily to game the IRS, you may be setting yourself up for disappointment. To ensure that you’re using life insurance appropriately, review your needs and expectations with a CPA, financial planner, and life insurance agent before making any decisions.