Introduction

Life insurance is a critical financial tool that can provide security for your loved ones. However, the tax implications of life insurance can be complex. This article will help you understand the tax rules for life insurance premiums, death benefits, and policy loans, so you can make informed decisions that protect your financial well-being.

Life insurance premiums: Not tax-deductible

Usually, life insurance premiums are considered personal expenses and are therefore not tax-deductible. This suggests that funds directed to premiums do not reduce your taxable income. Yet, if you are self-employed and the premiums are paid through your business, there may be exceptions. We advise consulting with a tax advisor to explore any potential exemptions.

Death benefits and other payouts

One of the primary advantages of life insurance is that death benefits are usually tax-free for beneficiaries. Here’s a closer look at the different types of payouts and their tax implications:

Lump-sum payouts: Not taxable

The face value, also known as the death benefit, is the amount beneficiaries receive when the policyholder passes away. If the beneficiary chooses to receive the money in a single lump sum, it is not considered taxable income. This can provide a significant financial cushion without the added burden of taxes.

Interest on installment payouts: Taxable

Some beneficiaries may choose to receive their death benefit in installments. In this case, the insurer places the full death benefit into an interest-bearing account. The principal portion of the payments is not taxable, but the interest earned is considered taxable income and must be reported on your tax return.

Income from permanent life insurance

Permanent life insurance, which encompasses whole or universal life policies, presents more than just a death benefit. These policies also include a cash value component, which can grow tax-deferred. Here’s what you need to know about the tax implications of permanent life insurance:

Living or accelerated benefits: Not taxable (usually)

Permanent life insurance policies often offer living benefits, enabling access to a portion of the policy's value during one's lifetime. The cash value accumulates interest on a tax-deferred basis, and withdrawals up to the amount of premiums paid are typically non-taxable.

Furthermore, these policies may be augmented with riders that offer accelerated death benefits (ADB) under specific conditions, such as terminal illness or the need for long-term care. These benefits are typically non-taxable, being viewed as medical reimbursements. However, if the benefits are directed to a party with a financial stake in the insured, they may be subject to taxation.

Loans: Not taxable unless the policy lapses

One of the unique features of permanent life insurance is the ability to borrow against the cash value. When you take out a loan, you generally do not owe taxes on the borrowed amount as long as the policy remains in effect. However, if the loan balance grows to exceed the policy’s cash value and the policy lapses, the excess amount becomes taxable income.

Surrender value: Partly taxable

Should you choose to surrender or cash out your permanent life insurance policy, you may receive a surrender value, calculated as the cash value less any applicable surrender charges. The portion of the surrender value that surpasses the aggregate premiums paid is deemed taxable income. For example, upon cashing in a policy with a $78,000 surrender value and $64,000 in premiums paid, your taxable income would amount to $14,000.

Employer-provided life insurance: May be taxable

Should your employer offer life insurance as part of your benefits, you may be liable for income tax on the premiums paid for coverage that exceeds $50,000. The death benefit of up to $50,000 remains tax-exempt, but any sum beyond that is deemed taxable income. Opting to cover the higher premiums personally renders those payments nontaxable.

Moreover, should your employer-provided life insurance policy have an accrued cash value, the interest on this value is also subject to taxation, but only upon the policy's liquidation.

Selling your life insurance policy

Selling a life insurance policy through a life settlement or viatical settlement can provide immediate financial relief, especially for those who are terminally or chronically ill. These settlements allow policyholders to receive a lump sum payment in exchange for transferring ownership of the policy, which can be crucial for managing medical expenses or improving quality of life. In most cases, the money you receive from selling your policy is not taxable; however, it’s important to carefully consider the terms and impacts of the transaction on your overall financial situation. If you profit from the sale—receiving more than the cash surrender value—you may be subject to income and capital gains taxes. It is advisable to consult with a tax advisor to fully understand the tax implications and ensure compliance with applicable tax laws. Before proceeding with a life settlement, consider the long-term financial needs of your beneficiaries, as selling the policy may affect the eventual inheritance or financial legacy initially intended.

Prudential does not provide tax or legal advice. Please consult your tax and legal advisors about your particular circumstances.

Conclusion

Understanding the tax implications of life insurance is essential for maximizing the benefits of your policy and ensuring that your loved ones are protected. By staying informed and working with financial professionals, you can make the most of your life insurance coverage while minimizing any potential tax liabilities

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