How Life Insurance Death Benefits Are Taxed (and When They Aren’t)

This is the fifth of a series of columns discussing life insurance. The purpose of these columns is to help federal employees and retirees understand their need for life insurance and the choices they have with the different types of life insurance policies to meet their needs. This column discusses the tax treatment of life insurance policies.

Income Taxation of Life Insurance Death Proceeds

As stated in Internal Revenue Code (IRC) section 101(a)(1), death proceeds paid out under a life insurance contract by reason of the insured’s death are excludable from a beneficiary’s taxable income for federal income tax purposes. This means that although there are some exceptions, the income tax treatment of life insurance death proceeds is generally favorable to individual taxpayers. However, the federal estate tax and gift tax treatment of death proceeds paid out from a life insurance policy is more troublesome and generally requires careful planning in order to minimize any potential estate tax liability and/or gift tax liability.

In order for life insurance proceeds to be paid out to a beneficiary income tax free, the requirement is that life insurance proceeds are paid solely by reason of the death of the insured. In addition, as passed into law as a provision of the Health Insurance Portability and Accountability Act of 1996 (HIPAA), certain qualified accelerated death benefits paid to the insured who is terminally ill and expected to die within 12 to 24 months are income-tax free.

Income Definition of Life Insurance

The income tax exclusion of life insurance death proceeds depends in part on whether the life insurance policy meets the definition of life insurance under IRC section 7702. In particular, a life insurance policy will qualify as “life insurance” for federal income tax purposes if it meets either of two tests.

The first test is called the cash accumulation test. This test generally applies to more traditional cash value policies (such as whole life insurance or universal life insurance). Under this test, the policy cash value is limited to the “net single premium” that is needed to fund the policy’s death benefit. The net single premium is calculated by the insurance company using an assumed investment interest rate and certain mortality charges.

The second test is a two-pronged test. Life insurance policies designed to pass the second test must qualify under both a guideline premium requirement and a death benefit requirement. The guideline premium requirement limits the total premiums that can be paid by the policyowner at any given time while the policy is in force. The death benefit requirement is met if the contract’s death benefit exceeds a specified multiple of the policy cash value at all times. The multiple varies according to the insured’s attained age. Universal life and similar cash value life insurance policies will be tested under the second two-pronged test.

Death Benefit Settlement Payout Options

Death benefit proceeds paid by the insurance company to a designated beneficiary upon the insured’s death may be paid under a variety of insurance settlement options. Some payment settlement options may include an interest component. The interest component of the payment is fully taxable. But the principal component of the settlement option (consisting of the death benefit proceeds) is income tax-free.

Common settlement options include the installment option, the life income option, the fixed amount option, and the interest-only option. Note that the component of each payment under a settlement option that is attributable to the death benefit proceeds of the life insurance policy (that is, the face amount of the policy) is nontaxable, while the component of each payment that represents interest on the death benefit proceeds is generally taxable. The portion of the payment that is attributable to the death proceeds is calculated by prorating the face amount of the life insurance policy over the settlement option’s payment period. This is called the excludable portion. Any amount of the payment in excess of the excludable portion represents interest which is fully taxable.

Deductibility of Life Insurance Premiums

The general rule is that premium payments for life insurance policies are not deductible for federal income tax purposes. It makes no difference what type of a life insurance policy — an individual policy or a group policy, a term life policy or a permanent cash value life policy. Individual life insurance premium payments are generally not tax deductible.

However, in certain situations life insurance premiums may be tax deductible because the premiums paid meet the definition of a potentially tax-deductible payment. An example is a life insurance policy in which the sole beneficiary is a charitable organization. The policyowner can deduct the premiums paid as a charitable donation. In order for the policyowner to benefit with respect to federal income taxes, the policyowner would have to itemize on his or her federal income taxes (file Schedule A). If the policyowner uses the standard deduction rather than itemizing, then the premiums paid would not be deductible.

In short, there are two important points to note when determining the deductibility of a life insurance premium payment. The first is that generally speaking, life insurance premiums are nondeductible for federal income tax purposes. The second is a life insurance premium may be tax deductible if the premium can be properly characterized as a specific type of potentially deductible expense under the Internal Revenue Code. This determination will usually require a knowledge of tax law; therefore, the advice of a qualified tax professional should be sought.

Group-Term Life Insurance

IRC section 79 provides an exclusion for the first $50,000 of group-term life insurance coverage provided under a policy that is provided directly or indirectly by an employer as an employee benefit. An example is the Federal Employees Group Life Insurance (FEGLI) program, in which the federal government sponsors a group term life insurance policy for permanent federal employees. There are two parts to the FEGLI program that federal employees are eligible to enroll in. The first part is the Basic Insurance Amount (BIA). The BIA is a federal employee’s current year Standard Form (SF) 50 salary. Employees who are enrolled in the FEGLI BIA pay two-thirds of the premium cost while their agencies pay the other one-third. The second part of the FEGLI program is the optional additional coverages (Option A — Standard; Option B — Multiple of Salary; and Option C — Family Coverage) in which employees pay 100 percent of the premiums with no federal government contribution to the premium cost.

Under IRC Section 79, an employer can exclude from an employee’s wages the cost of employer-paid premiums for up to $50,000 of group-term life insurance coverage. The employer can exclude the same amount from the employee’s wages when figuring Social Security tax under the Federal Insurance Contributions Act (FICA) and Medicare Part A (Hospital Insurance) tax. In addition, the employer does not have to withhold federal income tax from the wages when the group life insurance coverage is less than $50,000.

If the employer-sponsored group life insurance policy coverage exceeds $50,000 and the policy is provided directly or indirectly by the employer, then there are potential federal tax consequences. A group policy is provided directly or indirectly by the employer if the employer pays any portion of the premiums. Since the federal government pays one-third of the premiums of a federal employee’s FEGLI BIA coverage, the FEGLI BIA life insurance coverage is considered coverage provided directly by an employer, and the FEGLI BIA life insurance coverage benefit is potentially a taxable fringe benefit.

How much of an employer-sponsored group life insurance policy is taxable as an employee fringe benefit? The employer can exclude the cost of up to $50,000 of group-term life insurance coverage from an employee’s wages. The employer must include in a participating employee’s taxable wages the employer-paid premium cost of group-term life insurance beyond $50,000 worth of coverage, reduced by the amount the employee paid toward the life insurance coverage. The employer reports the taxable portion as wages in Boxes 1, 3, and 5 of the employee’s Form W-2 (taxable cost of group-term life insurance over $50,000, included in Boxes 1, 3 up to the annual maximum Social Security wage base, and 5) and in Box 12 (Code C: taxable cost of group-term life insurance over $50,000).

The employer determines the monthly cost of life insurance to include in an employee’s wages by multiplying the number of thousands of dollars of the insurance coverage over $50,000 (figured to the nearest $100) by the cost shown in the table below. For all coverage provided within the calendar year, the employer should use the employee’s age on the last day of the employee’s tax year. The employer must prorate the cost from the table if less than a full month of coverage is involved.

Cost per $1,000 of life insurance protection for one month (IRS Publication 15-B, Table 2-2):

The employer figures the total cost to include in the employee’s wages by multiplying the monthly cost by the number of months’ coverage at that cost. The following example illustrates:

Howard, aged 65, is a federal employee and enrolled in FEGLI BIA. Howard’s 2026 Standard Form 50 salary is $197,560. His FEGLI BIA life insurance coverage is equal to $200,000 ($197,560 rounded up to the next $1,000 equals $198,000, plus $2,000, equals $200,000). His annual premium cost for $200,000 of FEGLI BIA life insurance coverage is equal to $0.16 per $1,000 of coverage per pay date, times 200 (number of $1,000s), times 26 pay dates, which equals $832. Howard’s federal agency must include in Howard’s taxable wages what the agency contributes toward the premium cost for the excess $50,000 of FEGLI BIA life insurance coverage. The $200,000 BIA life insurance coverage is reduced by $50,000, which equals $150,000. According to the table above, the yearly employer cost of $150,000 of life insurance coverage for a 65-year-old is $1.27 per $1,000 of life insurance coverage per month, times 150 (number of $1,000s), times 12 months, which equals $2,286. The $2,286 is reduced by the $832 that Howard pays for FEGLI BIA life insurance coverage, which equals $1,454. Howard’s agency will therefore include $1,454 in Boxes 1, 3, and 5 of Howard’s 2026 W-2 statement. Howard’s agency will also enter $1,454 in Box 12 of Howard’s 2026 W-2 statement with Code C.