Federal Tax Considerations for Life and Health Insurance
Life insurance taxation
The death benefit is generally received income tax free, though it is included in the insured's estate if the insured held incidents of ownership at death. Cash value grows tax deferred; policy loans are not taxable while the policy remains in force; surrender is taxable only to the extent of gain over basis. A modified endowment contract loses favorable loan and withdrawal treatment - distributions are taxed on a last-in-first-out basis, with a 10% penalty before 59½. A transfer for value removes the income tax exclusion on the death benefit unless the buyer is the insured, a partner or partnership of the insured, or a corporation in which the insured is a key person. 1035 exchanges preserve basis. Dividends are taxable once they exceed premiums paid.
Premiums are not deductible for an individual. An employer may deduct premiums as a business expense, and group term coverage up to $50,000 is tax free to the employee; the cost of coverage above that amount is imputed income using the Table I rates.
Health and disability taxation
Employer-paid medical premiums are deductible by the employer and excluded from the employee's income; salary-reduction premiums through a cafeteria plan are pre-tax. Self-employed individuals may deduct health insurance premiums. Disability benefits are taxable when the employer paid the premium and tax free when the insured paid it with after-tax dollars - the single most tested tax point in disability. Tax-qualified LTC benefits are generally received tax free and premiums are deductible within age-based limits as a medical expense. Accelerated death benefits are generally tax free.
Trap: only the amount above $50,000 of group term is imputed - not the entire benefit.