Important Tax Issues for Life Insurance

This is the fourth of five columns helping federal employees understand their choices when it comes to life insurance policy ownership. This column discusses the various tax issues associated with life insurance ownership.

SEE ALSO:

• Choosing the Best Life Insurance Coverage for Federal Employees
• 10 Most Common Mistakes to Avoid When Purchasing Life Insurance

Deductibility of Life Insurance Premiums

In general, life insurance premiums are not tax deductible for federal and state income tax purposes. This rule applies regardless of who owns the life insurance policy, whether the policy is owned for personal or for business purposes, whether the life insurance policy is an individually owned policy or a group life insurance policy (such as the Federal Employees Group Life Insurance [FEGLI]).

For permanent (cash value) life insurance policies, there are premium guidelines with respect to how much the policy owner can contribute additionally in order to build-up cash value. Excess premium contributions could result in a modified endowment contract (MEC). Creating an MEC could result in the taxation of excess life insurance policy premium contributions.

Taxation of Employer-Sponsored Group Life Insurance

With respect to employer-sponsored life insurance (such as the FEGLI program) an employer can provide and pay a portion of an employee’s life insurance premium of up to $50,000 of group term life insurance coverage without any tax consequences. The amount of employer-paid premiums exceeding $50,000 of coverage will be added to the employee’s taxable income for that year and will appear on the employee’s annual W-2 statement. In particular, on the employee’s W-2, Box 12 with a Code “C” (Cost of Employer-Sponsored Life Insurance).

Taxation of Life Insurance Proceeds

Proceeds paid to beneficiaries under a life insurance contract by reason of the policy owner’s death are generally excludable from the beneficiary’s gross income (with exceptions, see below) for federal and state income tax purposes. The requirement for income tax exclusion is that they will be paid by reason of the policyowner’s death. For permanent (cash value) life insurance policies, there are premium guidelines with respect to how much an individual can contribute in order to build up cash value.

Proceeds paid under a life insurance contract by reason of the policy owner’s death to named beneficiaries are excludable from the beneficiaries’ gross income for federal income and state income tax purposes. The requirement of the income tax exclusion of the life insurance proceeds is that the proceeds are paid by reason of the death of the policy owner (the insured).

When Are Term Life Insurance Policy Proceeds Taxable?

The death benefit proceeds from a life insurance policy may be paid out in a lump-sum payment, or in a series of payments under a settlement option between the insurance company and a beneficiary. For example, payments under a settlement option are to be paid out over a three-year period, equally paid in each of the three years. The principal portion of a settlement option payment (the life insurance proceeds) qualify for income tax exclusion. Common settlement options include the installment option, the life option, the fixed amount option, and the interest only option. The amount of each payment under a settlement option that represents interest on the life insurance proceeds is fully taxable.

Life Insurance Policy Dividends

Some individual term life insurance policies pay dividends. Life insurance policy dividends are treated as a nontaxable return of premiums that the policy owner paid in prior years. Since the premiums were paid with after-tax dollars, the policy dividends paid are not considered taxable income to the policy owner.

Accelerated Death Benefit and Living Benefits

Since the passage of the Health Insurance Portability Accounting Act of 1996, life insurance policy owners who qualify for an accelerated death benefit (due to having a terminal disease with a life expectancy of less than two years) or for a chronic illness benefit (due to being chronically ill) are not subject to income taxes nor an early withdrawal penalty when they withdraw a portion or all of the life insurance death benefit.

Life Insurance and Estate Taxes

There is a federal estate tax in which the federal government has the right to tax a decedent’s estate if the value of the gross estate exceeds a specific amount. This specific amount is called the federal estate tax exemption. For the year 2024, the federal estate tax exemption is $13.61 million per individual and $27.22 million for a married couple. There are also 11 states and the District of Columbia that have their own state estate taxes. Six states impose an inheritance tax.

An estate tax is imposed on the value of the decedent’s gross estate as of the date of the decedent’s death. Some of the assets included in the gross estate are:

(1) Bank and brokerage accounts

(2) Real estate;

(3) Retirement accounts such as 401(k) plans, the Thrift Savings Plan, traditional IRAs and Roth IRAs;

(4) Personal items including heirlooms; and

(5) Life insurance policies including individually owned policies and group owned policies (such as the FEGLI program) and both term and permanent (cash value) life insurance policies.

Most individuals are not subject to the federal estate tax, a result of the huge federal estate tax exemption currently $13.61 million per individual. This will increase to $13.99 million per individual during 2025. However, the large federal estate exemption, a result of the passage of the Tax Cuts and Jobs Act of 2017 (TCJA) passed into law during 2017 and taking effect January 1, 2018, is due to expire December 31,2025 unless Congress renews TCJA. If Congress does not renew TCJA, the federal estate exemption will be lowered to $7 million, effective January 1, 2026. The 50 percent reduction to the federal estate tax exemption could result in millions more of Americans being subject to the federal estate tax.

For those individuals living in the 12 states including the District of Columbia that impose their own state estate taxes, the estate tax exemptions are much lower than the federal government’s $13.61 million exemption in effect during 2024. The following table shows the 11 states and the District of Columbia imposing state estate exemptions and their state estate tax exemption in effect during 2024. Note that the state estate tax exemption is as low as $1 million (Oregon) to as high as $13.61 million (Connecticut).

The following table shows the 12 states including the District of Columbia that impose state estate taxes during 2024 together with their exemption amounts:

Those federal employees and retirees who think that their estates will be subject to the federal and/or state estate tax are advised to contact an estate attorney in their state who can make suggestions to minimize the chances of having to pay an estate tax. One suggestion is to assign ownership of a life insurance policy to another individual or to an irrevocable life insurance trust.

 

In order for the death benefit payment from a life insurance policy to not be subject to a state inheritance tax, the life insurance policy owner should not name their will as the beneficiary of their life insurance policy; rather, they should name an individual beneficiary or a charity.