If you have the great fortune of holding down a job with fringe benefits like paid sick time and vacation, and health coverage through dental, vision and health insurance, you might also carry another benefit: group-term life insurance.
Most employers who offer fringe benefits with this option usually provide discounted coverage through a partnering insurer as a baseline and then the add-on possibility of carrying more to suit your needs.
While that provides for better financial security, Uncle Sam also has a vested interest in taking his fair share of any such benefit. And if you paid taxes on the front for this benefit, it begs the question “are life insurance proceeds taxable?”
To illustrate, as a general rule, anything an employee receives from an employer as compensation for services rendered – including fringe benefits of the likes mentioned above – counts toward their gross income under the Internal Revenue Code (IRC, section 61), unless specifically excluded by some other section.
In this case, IRC Section 79 provides such an exclusion, as discussed in more detail below.
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What is Life Insurance?
Insurance seeks to transfer risk from yourself to another party through the exchange of a stream of payments (premiums) for a lump-sum (or guaranteed stream of payments) at some point in the future. People who purchase life insurance pay premiums in exchange for receiving a death benefit to assist their beneficiaries with financial resources.
Life insurance comes in many different forms:
- Term life insurance
- Whole life insurance
- Permanent life insurance
- Universal life insurance
- Variable life insurance
- Variable universal life insurance
- Simplified issue life insurance
- Guaranteed issue life insurance
While all vary in form and structure, the primary idea behind life insurance includes the transfer of risk from the insured to the insurer through a life insurance contract.
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What is a Death Benefit?
The death benefit from a life insurance policy represents the amount paid to the beneficiary of the insured’s life insurance contract. At the insured’s death, the death benefit transfers to the policy beneficiary/(ies).
Alternatively, a death benefit also accrues in the situation of an annuity or pension-holder dying with payments still left on the financial instruments. In other words, the stream of payments received from the annuity or pension-holder’s account will continue (usually in a different amount) to pay after the death of the primary individual.
Are Life Insurance Proceeds Taxable?
For all life insurance policies meeting the definition of life insurance, any cash surrender value increases for the policy would not be taxed until received and the death proceeds would avoid taxation. In other words, generally speaking, life insurance proceeds (death benefit) do not have taxes paid against the proceeds.
In the event the insured carries a life insurance policy which pays cash dividends (e.g., whole life insurance), these dividends do not count as income on a taxpayer’s return. This passive income receives favorable tax treatment so long as the amount received does not exceed the net premiums paid on the policy.
What is Cash Surrender Value?
In insurance, when you voluntarily terminate your policy before its maturity or an insured event occurs in exchange for a discounted payout, you receive the cash surrender value. This represents the sum of money an insurance company pays to the policyholder or an annuity contract holder and amounts to a discounted payout from the full value of the death benefit, in the case of life insurance.
In practice, the cash surrender value should asymptotically approach the full expected payout value as the policyholder maintains the policy. In other words, as more time passes and the insured event nears, the insurer will charge a lower percentage in surrender charges.
The insurer calculates the cash surrender value by taking the full cash value payout and deducts the surrender charges, plus any unpaid loan principal or interest on the policy.
Do You Have to Pay Taxes on a Surrendered Life Insurance Policy?
While you may receive less in value by surrendering the life insurance policy, you will not lose the tax free status of the life insurance proceeds. Fortunately, the IRS does not assess any tax on the cash value of a policy and when you withdraw money up to your cost basis, this money also avoids taxation.
Further, should you opt to take a loan against your life insurance policy, you will not pay taxes on these funds as they do not constitute taxable income. However, in the event your policy lapses, you must pay income tax on your entire gain related to the life insurance policy.
Are Life Insurance Proceeds Tax Free?
In most circumstances, life insurance proceeds are tax free. When you or a beneficiary receives a death benefit related to a life insurance policy, the IRS does not considerable this taxable income.
Therefore, these proceeds escape taxation. However, any interest you receive tied to the life insurance policy is taxable and you should report it as interest received and include this in your taxable income.
Another circumstance where you might face tax consequences tied to a life insurance policy comes from the tax treatment of life insurance policy loans. Specifically, the tax treatment depends on whether the contract receives treatment as a modified endowment contract (MEC).
Most single premium life insurance policies qualify as MECs. For those life insurance policies entered into on or after June 21, 1988, which do not meet the seven premium payments test of IRC Section 7702A(b) classify as MECs.
Loans which use MECs as collateral (underwrite the loan), have tax repercussions. These loans count as taxable income at the time received to the extent the cash value of the contract immediately before the payment exceeds the investment of the contract. In some instances, these distributions may also face a 10% penalty.
Do You Get a 1099 for Life Insurance Proceeds?
Because proceeds from life insurance policies generally avoid taxation to the recipient, you will not receive a 1099 unless your life insurance payout counts as a taxable event. In this case, you will receive a Form 1099-MISC and will need to report this on your tax return as taxable income.
You will report the taxable amount of the policy on a Form 1099-INT, Form 1099-MISC, or Form 1099-R, depending on the type of taxable event.
Are Employer-Paid Life Insurance Proceeds Taxable?
Generally, life insurance proceeds you receive as a beneficiary due to the death of an insured person do not count as a taxable event. As a result, you do not include these life insurance proceeds, whether paid as an individual or by your employer, in your taxable income.
Further, you do not have to report these life insurance proceeds on your tax return.
Are Employer-Paid Life Insurance Premiums Taxable to Employee?
Per the Internal Revenue Code section 79, an exclusion exists for the first $50,000 of group-term (employer-provided) life insurance coverage provided under a policy carried directly (or indirectly) by an employer. In effect, no tax consequences come into effect if the total amount of insurance coverage provided by an employer does not exceed $50,000.
Therefore, for any amount of insurance coverage in excess of $50,000, the employee must include the imputed cost of coverage above this mark as taxable income (reflected on Form W-2). Further, this taxable income also falls under Medicare and Social Security taxation if within applicable income limits. 1099 contractors will not receive these benefits as they do not qualify as an employee of the company.
To calculate the taxable income amount for employer-paid group-term insurance above $50,000, the IRS maintains something called the IRS Premium Table in Publication 15-B.
Carried Directly or Indirectly by the Employer
As stated above, a taxable fringe benefit arises in the event the group-term life insurance coverage exceeds $50,000 and the policy classifies as directly or indirectly carried by the employer. To meet the criteria for carried directly or indirectly by the employer, the life insurance policy must have:
- The employer pay any cost of life insurance, or
- The employer arrange for the premium payments and premiums paid by at least one employee subsidize those by at least one other employee (triggering the “straddle” rule)
To understand more about this so-called “straddle” rule, see the Publication 15-B above for the IRS Premium Table rates. As a note, the determination of whether the premiums charges straddle the costs comes from those tables and not the actual cost.
As the employer affects the premium cost through subsidizing and/or redistributing the cost, employees receive a benefit. Because this counts as a fringe benefit (discussed above), this will count as taxable income for all amounts of coverage exceeding $50,000. The employee must calculate the taxable portion of the premiums for coverage exceeding this cap.
As an example, let’s assume your employer covers employees exclusively in the 25 through 29, 30 through 34, and 35 through 39 age brackets with group-term life insurance. In other words, young professionals.
The cost per $1,000 of life insurance coverage is $0.06, $0.08, and $0.09, respectively. Your employer pays the full cost of the life insurance on your behalf as a fringe benefit. Let’s imagine everyone in the first age category is 27, the second is 32, and the third is 37 and each category receives the same life insurance coverage (i.e., category 1 receives $50,000 of life insurance coverage, 2 receives $100,000, and 3 receives $150,000).
To calculate the taxable income the employees would claim on their tax returns, the first age category would have the entire benefit excluded as it meets the $50,000 exclusion.
For the second category (30 to 34 year olds), they would count $48 of taxable income on their tax return (([$100,000 – $50,000 exclusion] / $1,000) * $0.08 * 12 months). Likewise for the oldest category, they would claim $108 of taxable income (([$150,000 – $50,000 exclusion] / $1,000) * $0.09 * 12 months).
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Is Life Insurance Deductible for an S Corp?
To answer this question, let’s cut to the chase and say it depends. S Corporations can deduct life insurance premiums if the S corporation does not list itself as a beneficiary. In this case, the S Corporation can deduct life insurance premiums against its taxable income.
Also, the S Corporation will need to file a Form 1120S, also known as an information return. These forms include a portion which shows how their respective income (loss), deductions and credits pass through to the owners on their individual tax returns.
Is Life Insurance Deductible for an LLC?
The IRS has different rules in place for S Corps and LLCs with respect to the deductibility of life insurance premiums. While S Corps can deduct life insurance premiums, if the company does not list itself as a beneficiary, LLCs cannot deduct life insurance premiums against its taxable income.
The only exceptions occur when you own the LLC and pay the life insurance premiums for employees. In this situation, you may deduct life insurance premiums alongside any other relevant business startup costs.
Are Life Insurance Premiums Deductible for C Corporations?
For life insurance premiums paid by a C Corporation, companies may deduct them if used as security for a loan, similar to how they would for an individual. However, as a general rule, life insurance premiums, whether paid for by individuals or corporations, cannot be deducted from your taxable income.
Because the cash values and death benefit payouts avoid taxation, you cannot write off the premiums paid on your taxes.
About the Site Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
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