Life Insurance Taxation FAQs
How are life insurance death benefits taxed?
If you have a life insurance policy, you probably wonder if you or your beneficiaries will have to pay taxes on the life insurance proceeds. The general rule is that death benefits paid to a beneficiary are received income tax free. This tax-free treatment of death benefits is only available if the policy is not transferred or sold for cash or other valuable consideration.
Are accelerated death benefits included in taxable income?
Life insurance death benefits on the life of a terminally ill insured and paid before the
insured’s death may be income tax free. A terminally ill person is someone who has an
illness that is reasonably expected to result in death within two years. Most life
insurance policies today offer some type of accelerated death benefit for terminally ill
insureds, but the amount the individual can take as an early death benefit varies.
A chronically ill insured (one who is not terminally ill) may be entitled to receive
accelerated benefits tax-free, although fewer life insurance policies offer an accelerated
benefit for chronically ill insureds. The amount the chronically ill insured can receive
income tax-free from all life insurance policies and qualified long term care insurance is
limited to the daily amount allowed under long term care insurance policies. In 2006,
this amount is the greater of $250. (and changes annually for inflation) or the costs
incurred for qualified long term care services. Amounts received over the limit are
These rules generally do not apply to policies owned by an entity which the insured
serves as a director, officer, or employee.
Is the growth on policy cash value income taxable?
As long as the life insurance policy cash value remains in the policy, any growth in the
cash value is income tax-deferred. But once the money is removed from the policy,
there may be tax consequences.
In general, a policyowner is not taxed on cash value amounts equal to the policyowner’s
basis in the policy. The basis in a universal life policy is approximately equal to the total
amount of premiums paid for the policy. If the policy has riders the total cost of the
riders must first be subtracted from the total premiums paid to determine basis.
If a life insurance policy is surrendered for its cash value, any cash received will be
income taxable only if the amount exceeds the policyowner’s basis in the policy. If cash
values are removed from the policy through withdrawals or surrender, the policyowner
doesn’t have to pay tax on the amount equal to the policyowner’s basis in the policy.
Only value in excess of the policyowner’s basis is subject to income tax.
For life insurance policies that are not modified endowment policies (MEC), withdrawals
from the policy are taxable if the total withdrawals made exceed the basis in the policy.
In other words, the first withdrawals are assumed to be a return of the policyowner’s basis.
After the basis is completely removed, additional withdrawals will be subject to
income tax. If the policy is a modified endowment contract, withdrawals are treated as if
they came from the policy’s growth first.
If a policy with an outstanding loan is surrendered, what are the tax consequences?
All growth in the life insurance policy is income taxable upon surrender. If a policy with
an outstanding loan is surrendered, the amount of the loan paid off by the policy value is
treated as part of the cash received. If the policy has more cash value than is needed to
pay off the outstanding loan, the excess amount is given to the policyowner.
To determine gain or loss upon surrender, add the net cash surrender value to the
outstanding loan balance. And then compare that sum to the policyowner’s basis in the
policy. If it exceeds the basis, the policyowner treats the gain as taxable income. If the
sum is less than the basis, then the result is generally a non-deductible loss. Losses
upon the surrender of a life insurance contract are ordinarily not income-tax deductible.
If a policyowner has borrowed heavily against a life insurance policy before surrender,
this can result in “phantom income.” This means that the policyowner may have more
income tax liability than actual cash received.
Are life insurance premiums deductible?
Not usually. Premiums paid by an individual on a personally owned life insurance policy
are not deductible for federal income tax purposes. Likewise, premiums paid by a
business for insurance policies on a key person, to fund a buy-sell arrangement, and to
use as collateral for a business loan, are not income tax deductible by the business.
However, premiums paid by an employer to purchase group term life insurance on its
employees are deductible, provided the employer is not a direct or indirect beneficiary of
the life insurance.
(Courtesy: Genworth Financial).