Federal Tax Considerations for Life and Health Insurance
Life insurance taxation
The death benefit is generally received income-tax free, though estate tax may apply. Cash value grows tax-deferred. Policy loans are not taxable while the policy remains in force, but a lapse or surrender with an outstanding loan creates taxable gain. Dividends are a return of divisible surplus and are not taxable until cumulative dividends exceed total premiums paid. A MEC is taxed gain-first on distributions, with a 10% penalty before 59½. A transfer for value makes the death benefit taxable to the buyer unless an exception applies (partner or partnership, corporation and insured, divorce, or a carryover-basis transaction).
The death benefit is included in the insured's gross estate if the insured held incidents of ownership at death, including a policy transferred within three years of death under IRC 2035. A gratuitous transfer is a gift, but the marital and charitable deductions may apply. Employer-owned life insurance must satisfy the notice and consent requirements of IRC 101(j) or the death benefit is taxable.
Health taxation
Employer-paid premiums are deductible to the employer and generally excluded from the employee's income. Individually paid premiums are a medical expense deduction only above 7.5% of AGI and only when itemizing; self-employed individuals may deduct health insurance above the line. HSAs are triple-tax-advantaged when funds pay qualified medical expenses. Disability benefits are taxable when the employer paid the premium (or the employee used pre-tax dollars) and tax free when the employee paid with after-tax dollars. Workers' compensation and long-term-care benefits (subject to a per-diem cap) are tax free.
Retirement
Qualified-plan contributions are pre-tax or deductible, and distributions are ordinary income, with a 10% penalty before 59½ subject to exceptions such as death, disability, or qualified education expenses.
Trap: Saying the death benefit is income-taxable is almost always wrong; whether the policy is included in the estate is a separate question.
Rule of thumb: The tax treatment of a benefit follows who paid for it.