This is the second of three columns intended to help federal employees and retirees understand their choices and needs when it comes to life insurance.
This column discusses the income tax and estate tax consequences associated with owning a life insurance policy.
SEE ALSO: Federal Employees Should Review Their Life Insurance Needs and Choices
Income Tax and Life Insurance
Premiums paid by an individual life policyowner are paid with after-taxed dollars and with two exceptions (see below), are not tax deductible for federal and state income tax purposes. This is the case whether the policyowner has purchased an individual life insurance policy or the individual is enrolled in a group-sponsored life insurance policy (such as the federal government-sponsored Federal Eyees Group Life Insurance (FEGLI) program).
It should be noted that with respect to the FEGLI program, employees pay 2/3 of the premium cost for the FEGLI “Basic Insurance Amount” (BIA) (the premiums paid appear on an employee’s bi-weekly leave and earnings statement). The employee’s agency pays the other 1/3 of the premiums for the FEGLI BIA.
Employees pay the full premium cost (no agency premium contributions) for the three FEGLI optional coverages (Option A – Standard; Option B – Multiples of Salary, and Option C – Family Coverage) with no agency premium contribution. Employee premium payments for the Optional coverages also appear on an employee’s bi-weekly leave and earnings statement.
Life insurance premiums that the policyowner pays may be tax deductible under the following circumstances:
(1) The only life insurance policy beneficiary is a nonprofit organization such as a house of worship (church, mosque, synagogue).
In that case, the policyowner can include the premiums paid as a cash/check charitable contribution on Schedule A of his or her federal income tax return. To do so, the policyowner must itemize on his or her federal income tax return in order to deduct the life insurance premiums paid.
(2) As part of a pre-2019 divorce settlement, one spouse is required to pay alimony to the other spouse.
If the alimony payor spouse were to die, then alimony payments cease. The alimony payee spouse therefore demands (as part of the divorce settlement) that the alimony payor spouse take out a life insurance policy on himself/herself naming the alimony payee spouse as the sole life insurance beneficiary. At the death of the alimony payor spouse, the alimony payee spouse receives the life insurance proceeds.
The life insurance proceeds would take the place of the alimony payments which ceases at the death of the alimony payor spouse. Because the alimony payments in pre-2019 divorce settlements are tax deductible in most cases (as an adjustment to income), life insurance premiums paid are tax deductible. Note that under the Tax Cuts and Jobs Act of 2017, alimony payments made as a result of a post-2018 divorce settlement are not tax deductible to the payor spouse nor includible in the payee spouse’s income.
The life insurance proceeds paid in a lump sum to policy beneficiaries as a result of the insured’s death are generally excludable from the gross income of the beneficiaries. If instead paying beneficiaries in a lump sum payment following the death of the insured, an insurance company pays a beneficiary’s share of the life insurance proceeds in regular installments over time and includes interest with each installment payment, then the interest portion of the installment payment will be includable in the beneficiary’s taxable income.
Employer-sponsored life insurance such as FEGLI can provide employees with up to $50,000 of group term life insurance without any tax consequences. Those federal employees who are enrolled in FEGLI and who are insured for more than $50,000 of the BIA are taxed on the portion of the BIA that exceeds $50,000.
This is because the employee’s agency pays one-third of the premiums for an employee’s FEGLI BIA coverage. The portion of the premiums paid by the agency on an employee’s BIA exceeding $50,000 will be converted to income and appear as taxable income on the employee’s W-2 statement.
With respect to permanent (cash value) life insurance, when a permanent life insurance policyowner surrenders the policy for cash, proceeds in excess of the policyowner’s investment in the life insurance contract are generally taxable. A limited exception is available for terminally or chronically ill insured individual under Internal Revenue Code Section 101(g). The following example illustrates:
Example. Carl purchased a universal life insurance policy in 2013. He surrendered the policy for cash in June 2022 and received $13,500. His premiums over 9 years of ownership totaled $7,200. His cost basis in the insurance policy was reduced by $2,200 of dividends paid to Carl but he did not report as income. His taxable proceeds resulting from the surrender of his universal life insurance policy is:
$13,500 less ($7,200 less $2,200) equals $8,500
Estate Tax and Life Insurance
Life insurance proceeds are included in a decedent’s gross estate if:
• The estate receives the proceeds
• A beneficiary other than the estate receives the proceeds but is legally obligated to pay taxes, debts, or other obligations of the estate from the life insurance proceeds, or
• The decedent owned the policy or had any “incidents of ownership” in the policy within three years of death. Incidents of ownership include the right to change or veto a change of beneficiary; the right to pledge or borrow against the policy; and the right to surrender, cancel, or revoke assignment of the policy.
To avoid inclusion in the gross estate, a life insurance policyowner should make sure that:
• The insured’s estate is not the beneficiary
• A life insurance policy should be owned by someone other than the insured, either another individual or a trust (however, it is highly recommended that the insured’s spouse should not be the owner)
• If ownership of an existing life insurance policy is transferred, the insured must relinquish all control of the policy and live at least three years from the time of transfer (the “Three-Year” rule).
• If the individual who owns the policy is not the beneficiary, then the life insurance proceeds may be considered a taxable gift from the owner to the beneficiary. To avoid this, the beneficiaries should own the policy, or an irrevocable trust should be both owner and beneficiary
• Once the ownership of a life insurance policy is given to children or other beneficiaries, the policyowner loses control. The new owner can change beneficiaries, cash out the policy or borrow against it. The insurance policy may also become subject to the claims of the new owners’ creditors or divorcing spouses.
An Irrevocable Life Insurance Trust (ILIT) can be used to avoid these problems. Although the policyowner must still surrender control to gain the estate tax savings, the policyowner gives control to a trustee under terms the policyowner selects. A trust can also be used to keep the insurance proceeds available for a surviving spouse without losing the estate tax savings.