Is life insurance tax deductible in 2021?
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Life insurance is often considered an essential investment, which provides financial security at the cost of set premiums. But are there ways to offset the cost — are life insurance premiums tax deductible? Despite popular assumption, life insurance premiums are not usually tax deductible.
Many investments that fall within the realm of responsibility are not tax deductible. Paying for maintenance on a car is one example. Unless it’s a company vehicle, this investment does not qualify as deductible. Life insurance premiums are the same way, in most cases. However, there are some situations in which premiums can be tax deductible. Beyond rates, there are also other tax nuances to be explored with life insurance policies.
What is a tax deduction?
A tax deduction is an amount of money that can be subtracted from a person’s owed taxes. The IRS specifies an extensive list of qualifying tax deductions for both individuals and businesses. Individual tax deductions are broken down into five categories: work-related, itemized, education, health care and investment-related.
A classic example of tax deductions would be charitable giving. When you drop off a box of donations at a Goodwill or similar organization, you can receive an itemized receipt. This itemized receipt can then be used when you’re filing taxes. The amount listed by the charitable organization on that receipt can be factored into your taxable income. Essentially, the amount that you owe will be reduced by the receipt amount. When it comes to life insurance, your payments cannot be itemized and deducted in the same way.
Why isn’t life insurance tax deductible?
The primary logic behind life insurance not being tax deductible is that there is no state or federal mandate for life insurance. Life insurance policies fall under the category of personal expenses, much like buying a coat or a ticket to a concert. While purchasing a life insurance policy might be a responsible choice, that doesn’t inherently qualify it for a tax deduction.
Suppose federal or state governments pass a law mandating life insurance. In that case, the chances are good that life insurance premiums would become tax deductible. For now, life insurance premiums are, by default, not tax deductible. That said, there are some rarer situations where some premiums can be tax deductible.
When is life insurance tax deductible?
Although life insurance premiums usually are not tax deductible, there is a situation in which they can be. Specifically, this can occur for business owners when it comes to business-related life insurance policies. Beyond this life insurance tax deductibility, there are a few other potential tax benefits to life insurance policies.
As a business owner
Business owners can claim tax deductions on the life insurance premiums that they pay on behalf of their employees. For example, say Jeff runs a shop with three employees who all have company life insurance policies. Jeff can claim the premiums that his business pays towards those policies as a tax deduction. However, these deductions can only be applied to premiums paid for the first $50,000 of coverage for each employee.
Tax-deferred growth on cash value components
Most whole life and universal life insurance policies have a cash value investment component. These funds are generally tax-deferred, meaning that taxes do not need to be paid on them until they are withdrawn. One of the benefits of this is that these funds may eventually be used to pay the policy premiums without withdrawing the funds.
Do you pay taxes on life insurance?
Life insurance payouts can be a little tricky when it comes to taxes. Death benefits are generally tax-exempt. However, any interest accumulated within that payout would be taxable. Further complicating things, life insurance policies can be gifted, surrendered and sometimes withdrawn from. Each of these scenarios interacts differently with the tax code.
Interest earned is taxable
Any interest gained within a life insurance cash value component or within the death benefit is considered taxable. Some of the money within a policy investment (the cash value) comes directly from premium payments; this amount is not taxed. However, if that money grows through interest while invested, then that growth is taxed. For instance, consider a whole life insurance policy with a cash value of $5,000 that has had $4,000 in premiums paid on it. The difference of $1,000 would be subject to income tax, while the other $4,000 would not. However, since cash value components on these policies are usually tax-deferred, this would only occur once that money was withdrawn.
When surrendering the policy
This is another situation where the interest growth of the cash value component becomes relevant for tax purposes. Suppose you surrender a policy for the cash surrender value. In that case, any amount received more than what has been paid in premiums is taxable. For instance, if someone has paid $1,200 in premiums on a policy and receives $5,000 for surrendering it, the difference of $3,800 will be taxable.
If the policy is purchased for another
If one person takes out a life insurance policy for another person and then names a third person as the beneficiary, the exchange may be subject to a gift tax. Imagine that Bob takes out a life insurance policy on his wife, Sally. Their daughter Jane is listed as the beneficiary. When Sally dies, the policy will pay out to Jane, but Bob may owe a gift tax on the death benefit.
- Life insurance premiums are generally not tax deductible.
- Employee life insurance premiums paid by a business are tax deductible for that business, up to a point.
- The money received from surrendering a policy is tax-exempt up to the sum of premiums paid into it.
- Interest gained within permanent life insurance policies is taxable.
- Death benefits are usually not taxable.
Life insurance premiums are not tax deductible except for specific circumstances, like when employers pay for some of their employees’ premiums. Although the premiums are not tax deductible for most, neither is the life insurance payout generally taxable for beneficiaries. Overall, life insurance is treated by the IRS as being a personal expense and does not engender the type of preferential tax treatment that some expenditures do.