Term life insurance is a straightforward and affordable way to provide financial protection for your loved ones. It offers coverage for a specified period (the “term”), typically 10 to 30 years, and pays a death benefit to your beneficiaries if you pass away during the policy term. Unlike whole or universal life insurance, term life insurance doesn’t accumulate cash value or come with investment components. While term life insurance is simple, many people have questions about how it interacts with taxes. This post will clarify the tax implications of term life insurance for policyholders and beneficiaries.
1. Are Term Life Insurance Premiums Tax Deductible?
One of the most common questions about term life insurance and taxes is whether the premiums are tax-deductible. Unfortunately, the answer is no.
Premiums paid for term life insurance are considered personal expenses and are not deductible on your federal income tax return. This applies whether the policy is for personal use or taken out through a business.
Exceptions for Businesses
If a business provides term life insurance as part of an employee benefits package (for example, group life insurance), the premiums may be deductible as a business expense. However, the coverage amount that can be tax-free to the employee is typically capped at $50,000. Any coverage above this amount may have tax implications for the employee, as the excess coverage could be considered taxable income.
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2. Is the Death Benefit Taxable?
One of the most significant tax advantages of term life insurance is that the death benefit is generally not subject to federal income tax. If you pass away during the term of the policy, your beneficiaries will receive the full death benefit tax-free in most cases.
Estate Taxes
While the death benefit is not considered taxable income for your beneficiaries, it could be subject to estate taxes if your total estate (including the life insurance payout) exceeds the federal estate tax exemption limit. For 2023, the estate tax exemption is $12.92 million per individual. If the life insurance payout pushes your estate over this limit, estate taxes may apply. To avoid this, some people set up an irrevocable life insurance trust (ILIT) to keep the proceeds outside their taxable estate.
Interest on Death Benefit
If your beneficiaries choose to receive the death benefit in installments rather than a lump sum, any interest earned on these payments would be taxable as ordinary income. The original death benefit, however, remains tax-free.
3. Is There a Tax on Term Life Insurance Policy Loans or Cash Value?
Unlike whole or universal life insurance policies, term life insurance does not accumulate cash value over time. Therefore, there are no concerns about taxation on policy loans, withdrawals, or surrendering the policy for its cash value because these options don’t exist with term life insurance.
This simplicity is one of the reasons why term life insurance is often more affordable than permanent life insurance policies. It provides pure death benefit protection without the complexities associated with cash value growth and the potential tax consequences of accessing that cash.
4. What Happens if You Let a Term Life Policy Lapse?
If your term life insurance policy lapses (meaning you stop paying premiums), there are no direct tax consequences. The policy expires, and you or your beneficiaries will no longer have coverage. Unlike permanent life insurance policies, which may have tax implications if you let them lapse after taking loans or withdrawals from the cash value, a term policy has no cash value to worry about. You won’t owe taxes, and there are no penalties for letting the policy lapse.
5. Term Life Insurance and Gift Taxes
If you purchase a term life insurance policy and designate someone else as the owner, or gift the policy to another person, this may trigger gift tax consequences. For example, if the policy’s value (or future premiums you pay on someone else’s behalf) exceeds the annual gift tax exclusion amount, which is $17,000 per recipient in 2023, the excess may count toward your lifetime gift tax exemption.
However, gift taxes rarely come into play for term life insurance policies since they don’t build cash value, and the premiums are usually not high enough to trigger gift tax rules.
6. Group Term Life Insurance and Taxes
If you receive term life insurance coverage through your employer, the first $50,000 of coverage is generally tax-free. However, if your employer provides more than $50,000 in coverage, the value of the additional coverage will be considered taxable income and may increase your overall taxable income for the year.
The IRS requires that the value of the coverage exceeding $50,000 be calculated using a formula based on your age and the amount of coverage provided. The amount calculated is then added to your W-2 form as imputed income, and you may owe taxes on this portion.
Conclusion
Term life insurance is one of the simplest and most affordable ways to protect your family financially, and its tax treatment reflects this simplicity. Premiums are not tax-deductible, but the death benefit is generally tax-free, providing a significant advantage to beneficiaries. Since term life insurance doesn’t accumulate cash value or offer complex investment features, there are fewer tax concerns compared to permanent life insurance policies.
If you have questions about term life insurance and how it fits into your financial plan, I’d love to help you. Schedule a phone call today!
