Taxation of Life Insurance
General rules
Life insurance death benefits are generally income-tax free to the beneficiary. Cash value grows tax-deferred. Premiums are generally not deductible for personal policies; employer-owned group coverage may be deductible as a business expense.
Taxable events
- Interest on proceeds left with the insurer is taxable.
- Surrender gains above basis are taxable.
- Policy loans are generally not taxable unless the policy lapses or is surrendered with an outstanding loan.
- Transfer-for-value can make proceeds taxable.
- MEC (modified endowment contract) rules: distributions are LIFO and pre-59½ withdrawals may incur a 10% penalty.
Estate taxation
Proceeds are included in the insured's gross estate if the insured owns the policy or holds incidents of ownership at death. An irrevocable life insurance trust (ILIT) can remove proceeds from the estate.
Traps
- Assuming all life insurance is tax-free - estate tax may apply.
- Forgetting that MEC distributions are taxed LIFO with penalties.
- Confusing income tax treatment with estate tax treatment.
Rule of thumb
Income tax: generally tax-free. Estate tax: included if the insured owns the policy or holds incidents of ownership.