Understanding taxes on Life insurance premiums

October 26, 2021

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RHI Agency Team

A Life Insurance policy is more like a superhero. It helps the insured right when it should. We are no longer discussing whether or not we should buy a life insurance policy- since we have come to an understanding that the benefits are striking. It is crucial to understand other things related to a life insurance policy, such as the amount of cover, policy tenure, coverages, and benefits. There is another factor that is subjected to changes and should be understood thoroughly. It is the tax implications associated with life insurance premiums. IRS (Internal Revenue Services) have imposed different taxes on different plans with arbitrary distinctions. You will need expert guidance to help you understand the tax implications associated with your insurance premiums. 

What to consider first?

If you want to purchase a life insurance policy and have little knowledge about how to go for it, you will have to consider many things to make a correct choice. The first and most important thing to understand is the difference between whole life insurance and term life insurance. If you take the whole-life insurance policy, it is effective for life. On the other hand, term life insurance provides coverage for a definite number of years. It is also crucial to calculate coverage required by the intentional buyer. The calculation is dependent on the reason as to why you are buying the policy in the first place. 

The death benefit amount that you opt for depends on your understanding of your needs. For example, if you want a life insurance policy only to cover your burial and funeral costs, you can go for a death benefit of a few thousand dollars. On the other hand, if you have a family dependent on your salary to pay for their bills and school, you might want to plan more than just your funeral costs. You have to calculate the college funds while counting in the daily expenses which can incur once the salary cheque is not around. You will also have to do a fair bit of research while selecting an insurance company. It is now somewhat easy to decide based on the internet reviews and by comparing the quotes from various insurance companies, side by side. 

Taxes on premiums

When you buy a life insurance policy, you don’t have to pay the sales tax. The premium amount quoted to the policyholder when the coverage is obtained is the amount that the policyholder pays. No percentage amount is added to cover the taxes. But, there are certain specific situations where the policyholder has to pay taxes even on the premiums. These situations can arise when you have employer-paid life insurance, prepaid life insurance, or cash value plans. 

Employer-Paid life insurance

When a company offers a life insurance policy as a part of overall compensation, Internal Revenue Services consider this an income, and the employee has to pay taxes. The taxes, however, are applicable only when the employer pays more than $50000 as life insurance coverage. In such a case as well, the employee is exempted from taxation on the premium cost of the first $50000 coverage. Here is an example. An employer is paying its employee $50000 life insurance coverage for the duration of the employment. This coverage is in addition to other gains like salary and health benefits. In such a case the employee does not have to pay taxes on the life insurance coverage benefits because it does not cross the IRS tax threshold. 

If an employee is provided with coverage of, say $100000 for the duration of their employment, with other benefits, the employee has to pay the taxes on the taxable part of it. In this case, $50000 in coverage is more than the IRS threshold and is considered taxable income. So, if the employee goes on to receive a $100 premium amount, the taxable amount is the premium paid on the additional $50000 (amount which exceeds the tax threshold), which in this case will be $50.

Prepaid life insurance

When the policy allows the holder to pay an upfront premium as a lump sum, it is referred to as prepaid life insurance. The money paid is then applied to the premiums throughout the plan duration. A lump-sum payment, in these cases, continuously grows in value due to interest. IRS considers this growth of money due to interest, an income source, and is therefore subjected to taxes when applied to the premium payment. Another case where taxes become applicable is when the policyholder withdraws some or all of the money they earn. 

Cash value plan

Whole-life insurance plans provide the insured with a specific death benefit (as fixed), and some whole-life insurance plans have a benefit of accumulated cash value, which is given to policyholders as they pay into the plan with premium dollars. A specific part of the premium dollars flows into a fund that accumulates some interest. When such policies are in place for a longer duration, the cash value exceeds the amount paid in premiums. These policies are a favorite for people who want an investment vehicle, along with other core benefits of a life insurance policy, such as financial protection in case the breadwinner dies. So, when the cash value increases over time, it brings in tax implications as enforced by the IRS. 

When a policyholder opts for whole life insurance plans, he/she does not have to pay the taxes every year on growth in cash value. Much like the 410 (k) plans, the cash value in whole life insurance plans is tax-deferred. The money qualifies as an income, but the IRS has deferred the tax payments until the policyholder cashes out the policy. When policyholders decide to cash out the plan, they are subjected to payment of tax on the difference of the cash value they receive and the payments they make on premiums. So, if the policyholder pays $24000 in premiums for 20 years and then cash out the policy to receive $30000, he/she has to pay tax on the difference, which is $6000.

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