All You Need to Know About Life Insurance and Taxes

All You Need to Know About Life Insurance and Taxes
Seguros de vida e impuestos

One of the most misunderstood aspects of life insurance is its relationship to taxes. In general, people think of life insurance as instruments that are largely tax-exempt. This is true for the most part, but there are some ways in which taxes can greatly impact life insurance and the profits it earns.

In this article, you will find basic information about the relationship between life insurance and taxes. Depending on this relationship, your insurance could earn you more--or less.

Life Insurance and Taxes: Article Contents

Life Insurance and Taxes: It’s Not What You Think

If you have life insurance, you’ve probably been told that it is virtually tax-free. This isn’t entirely true. While life insurance receives favorable tax treatment, some aspects are subject to taxes and fees.

For example, there are taxes on your gains when you surrender a policy. In some states, you will also have to pay fees if the insurance is part of an estate, or if you sell your policy.

However, with the right know-how, you can use your insurance to pay less taxes, or even to save and build an estate that is less burdensome on your heirs.

Another important detail to keep in mind is the deductibility of payments made toward purchasing and maintaining your life insurance. For example, the premiums you pay on a regular basis are generally not tax-deductible, but there are special cases in which you can deduct these costs.

You should also keep in mind that US tax laws can be very specific, which makes it difficult to establish general rules and much more difficult to offer advice that is applicable in all cases. For example, the tax treatment of an insurance policy varies depending on the amount of premiums that have been paid. Once you reach a certain limit of payments, the policy becomes a modified endowment contract (MEC). In this situation, any cash withdrawals from the policy are taxable as ordinary income.

As such, in addition to reviewing the information in this article, you should always seek out the advice of an expert. An insurance agent or tax advisor can expand on this information and give you recommendations specific to your situation.

When Would You Pay Taxes on Your Life Insurance?

There are some parts of your policy that are subject to taxes and concrete cases in which you would need to pay them. The most important ones are:

  • Gains on policy surrenders. If you surrender your policy, you will receive any cash value from the life insurance accumulated up to that point. Thanks to investment, this amount might be greater than the amount you paid in premiums, so it is not considered an investment, but rather a gain. As such, it is subject to taxes.
  • Unpaid loans against the policy. With permanent life insurance, you can take out loans against the cash value the policy accumulates. These loans must be repaid with interest. If the policy expires or is surrendered before the loan is repaid, you will have to pay taxes on the part of the loan balance that exceeds what was paid into the policy.
  • Estate taxes on insurance payouts. If your death benefit is considered part of the estate that you are leaving to your heirs, they may be charged estate taxes on this money.
  • Life insurance sales. If you agree to transfer ownership of your life insurance to someone else, you will have to pay taxes on the profits of this sale. In this transaction, you would sell your policy to another person, so this person would be responsible for paying the premiums and, upon your death, would receive the payout. In exchange, you will receive cash that will be subject to taxes.
  • Cash value withdrawals. Be mindful of how much cash you withdraw from your permanent insurance policy. If you exceed the amount paid in premiums, you will have to pay taxes on this money.
  • Group insurance. If your group insurance, offered by your company, offers a payout of over $50,000, the premium payments by your employer are considered a type of remuneration and so are subject to taxes.

Taxes and Life Insurance Payouts

It’s a well-known fact that life insurance beneficiaries do not pay taxes on the money they receive as a payout. But there are cases in which this money is taxable, and they are more common than you might think. The most common ones are:

  • Installment payouts. Sometimes, an insured person decides that their beneficiaries will receive their payout in regular or varied installments. This way, the bulk of the payout, which remains in the hands of the insurer, will earn interest. This interest is taxable. There are also instances in which the payout is delayed even if it is made as one lump sum, and not in installments. If it earns any interest during this time, that is also taxable.
  • Insurance as part of an estate. When a policy forms part of an estate large enough to be subject to taxes, these taxes will also apply to the payments made from the policy. In 2018, over 11 million euros were collected in estate taxes. Many people try to avoid this problem by transferring the policy to an irrevocable trust. But if this is not done within three years of the death of the insured, the benefit will continue to be subject to taxes.

What Parts of Life Insurance Are Tax-Free?

Apart from the taxable aspects we’ve seen, the truth is that life insurance generally receives favorable tax treatment. Many elements are tax-exempt. The main ones are:

  • Benefit payouts. Except in the cases we mentioned above, insurance payouts are generally given to beneficiaries tax-free.
  • Payouts to spouses. Payouts are always exempt from taxes when the beneficiary is the insured’s spouse.
  • Cash value gains. The cash value from permanent insurance pays deferred taxes, so it’s not necessary to constantly pay taxes on these gains.
  • Dividends. Some types of policies pay annual dividends to their policyholders; these are not subject to taxes.
  • Cash value withdrawals. As long as any cash you withdraw from your policy does not exceed the cash value, it is not subject to taxes.

What Can You Deduct with Your Life Insurance?

One important part of life insurance taxation is deductions. There are some aspects of your policy that you can deduct from your taxes. They are:

  • Premiums. In general, your regular premiums are not deductible. However, premiums on which another person pays taxes, such as in cases of alimony, are tax deductible. These premiums pay for insurance for which your ex-spouse, for example, is the beneficiary. These agreements are common in divorces and in this case, you can deduct the cost of the premium.
  • Group insurance premiums paid by you. If you are an employer and pay life insurance premiums for your employees, you can deduct the cost of these regular premiums as long as you are not the beneficiary of those policies. In this case, this will always apply for the first $50,000 of the payout. Beyond that, the taxes will be applied to the insured.
  • Donating policies to charity. If you transfer control of a policy to a charity, so that the charity is your life insurance beneficiary, you can request a tax deduction.

As you can see, the relationship between insurance and taxes is intricate and complex. There are many situations, variants, and exceptions that vary widely between states. As such, it is important that you seek expert advice to ensure that you pay only what is required in taxes.

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