Taxes and Life Insurance
Updated: Oct 10
Cash value accumulation
Death benefit proceeds Not all policies will have all 3 phases, for example a term policy does not build up cash value, or a whole life policy can be surrendered for its cash value prior to maturity.
Premium Payments Premiums are usually treated as a regular expense, and are therefore not tax deductible. Unlike other expenses or types of insurance where they may be written off, life insurance is considered an asset and thus the premiums do not come off of your balance sheet upon tax filing. There is one exception to this rule, wherein the premiums of a policy can be deducted from your gross income, and that is when the life insurance policy is within a tax qualified plan such as a 401k. There are many regulations as to how this may be setup and it is usually not practical or efficient. However, in short, the life insurance policy may not be more than 49% of the qualified plan holdings. The life insurance aspect of the policy does still have a taxable gain to the insured as well. So even though the premiums will be tax deductible, there will still be a tax bill for the taxable benefit of having a life insurance policy. This cost is either the price of a one year non renewable term, or based on the tables released by the IRS. Because of this taxable benefit, a term policy is not a viable option within a qualified plan as the benefit would be rather small. (I.e. The difference between the actual level premium term cost and the one year term premium is not drastic enough to warrant the costs and difficulties of creating a 401k. That difference will also decrease every year the policy is in force as the insured ages.) Upon distribution of the qualified plan, there will be taxes, just like any other qualified distribution. However, over here the correct strategy should be used to enable tax free access to the death benefit as will be discussed later on in the benefit distribution section.
Cash Value Accumulation The cash value in a life insurance policy builds up on a cash deferred basis due to IRS code 7702. What this means practically is, all the guaranteed cash value, plus the dividends deposited into the policy will be received and grow without any taxes being assessed. The reason why it is tax deferred and not tax free is, upon withdrawal from the policy due to either partial or full surrender, there will be a tax bill on all amounts above the basis paid into the policy. That amount will be taxed at regular income. In order to avoid paying any taxes on the policy, once the basis is withdrawn from the policy, you can loan the remaining amount needed, provided that it doesnt lapse the policy. Being that it is a loan for personal use, it will not be taxed. Be mindful that loans do affect the policy values and will accrue interest. Depending on the insurance company and type of policy, the dividends can be affected as well. (Referred to as Direct Recognition wherein the insurance company adjusts the dividend interest rate due to the loan being taken from the policy.) The chart below illustrates the true advantage of having tax deferred growth. The IRR is significantly higher when you factor in the taxable equivalent of the policy.
Another situation where the cash values can be taxable is when the policy is a Modified Endowment Contract (MEC). When a policy is a modified endowment contract it operates in a manner similar to that of a qualified retirement plan. Meaning, the cash values would still grow tax deferred, however distributions would be different. Unlike a regular life insurance policy that is not a modified endowment contract, where you can withdraw the basis first tax free. (First in first out FIFO.) With a policy that is a modified endowment contract, everything is taxed immediately upon withdrawal until all the gains are received and only then is the basis tax free. (Last In Last Out LIFO.) Additionally, all distributions prior to age fifty nine and a half are levied with a ten percent penalty. Here is a link to IRS code 7702 discussing tax deferred cash value growth as well as Modified Endowment Contracts.