 Personal Finance PowerPoint Presentation, taxes on life insurance premiums, prepare to get financially fit by practicing personal finance. Insurance is part of our long-term risk mitigation strategy where we follow the adage of measure twice cut once put in a formal process in place, looking something like set the goals, develop a plan to reach them, put the plan in action, review the results and repeat the process periodically. Most of this information can be found at Investopedia, understanding taxes on life insurance premiums which you can find online. Take a look at the references, resources, continue your research from there. This by Greg DeParsio, updated June 7, 2022. In prior presentations, we've been talking about insurance in general. We've been going into the life insurance, keeping the two major categories of life insurance in mind, one the term life insurance, the pure life insurance, the one we want to be using as our ruler, as our measuring tool, comparing everything else to the other being the permanent life insurance. Keeping that in mind, let's talk about understanding taxes on life insurance premiums. Life insurance is a financial product that pays out a lump sum in the event of the insurance death, providing financial support to one's beneficiaries and heirs. The death benefit coverage remains in effect so long as the policy holder pays the insurance premiums payments on the policy. So we've been talking about the general structure of life insurance in prior presentations, this being a recap of it. The premiums owed for a policy will depend on the insurance age and health, the younger and healthier, the less expensive, that should kind of make sense given the workings of how the life insurance company is going to be setting up life insurance. If you're younger, then you're probably going to get a cheaper policy given the fact you're less likely to die, along with the size of the death benefit. So how much someone's going to receive at the point of death and whether or not it is term or permanent coverage term typically being cheaper because it's simply life insurance without like an investment component to it and it has an end date that's set because life insurance is intended to support one's beneficiaries. The IRS treats it differently than other types of financial products. So it is important to consider the tax implications when you're buying life insurance. So obviously taxes best everything up, they confuse stuff a bit so the taxes come into play. The Internal Revenue Service, the IRS imposes different tax rules on different plans and sometimes the distinctions are arbitrary. If you're looking for reason in the tax code, sometimes you're looking in vain. But in any case, the following guide is meant to help explain some of the tax implications surrounding life insurance premiums, understanding life insurance. A person shopping for life insurance has many things to consider before making a decision first. There is the distinction between term life insurance and whole life insurance. We've discussed this a bit in the past recapping here. Term life provides coverage for a set number of years while whole life policy is effective for life. A policy holder also must calculate how much coverage they need, how much coverage they need for their beneficiaries and the event that they die, for example. This depends largely on why they are buying life insurance. If you are only concerned with covering your own burial and funeral costs for your next of kin, meaning you want to make sure that they're not burdened with the cost of funeral expenses, you may opt for a death benefit of 20,000 or less. By contrast, if you have several dependent children, all of whom hope to send to the college in the future, you will probably want $500,000 or more in coverage in that case. Further complicating the buying process is the sheer number of life insurance companies from which to choose. So it could be a little bit complicated to see who you're going to be dealing with and what kind of policies you're going to be using. The internet has made this process somewhat easier. It surely has because you can do a lot better comparing and contrasting with several sites dedicated exclusively to comparing quotes from dozens of life insurance companies side by side, unlike buying a car or television set by life insurance does not require the payment of sales tax, which is nice. So this means the premium amount you amount you as the policyholder are quoted when you you obtain coverage is the amount you pay with no percentage amount added to cover taxes because you don't have the sales tax in that case. That said, certain situations exist in which a policyholder is required to pay taxes on insurance premiums. So employer paid life insurance when an employer provides life insurance as part of an overall compensation package. The IRS considers it income. So this of course kind of makes sense because when you're an employer employee situation, you're often looking for situations where you can get benefits from the employer that are not included in income, but you would have to have some specific reasons for them not to be included in income. If the employer gives you something that's not exact, not cash, like a car or something like that, then it still might be of course income. Some things might be exempt like putting money in a 401k plant or something like that, which have to be specifically exempted possibly from, you know, the IRS code. So the IRS considers it income, which means the employee is subject to taxes in that case because they got income in the form of an asset and insurance coverage. However, these taxes only apply when the employer pays more than $50,000 in life insurance coverage. Therefore, you might be able to get some tax advantage benefit if you get the policy through the employer, but it may not be enough to kind of cover your full needs with regards to life insurance coverage. So even in those cases, the premium costs for the first $50,000 in coverage is exempt from taxation. If, for example, an employer provides an employee for the duration of their employment with $50,000 in life insurance coverage in addition to their salary, health benefits and retirement savings plan, the employee doesn't have to pay taxes on the life insurance benefits because it does not exceed the threshold set by the IRS, which is nice. Alternatively, if the employer provided life insurance coverage is for $100,000, the employee has to pay taxes on part of it, which kind of makes sense because they went over the threshold. They're getting a benefit, which is basically income, and the IRS is granting some benefit from it to have some of it possibly non-taxable, and that's going to be a grant basically from the IRS for specific situations for specific benefits. So the premium dollars that pay for the $50,000 in coverage they receive in excess of the IRS threshold count as taxable income. So if you were to set that up, then on your W-2, you might have, for example, part of that benefit that you received included in line one taxable income of the W-2, for example, possibly. Therefore, if the monthly premium amount is $100, the amount that is taxable is the amount that pays for the additional $50,000 in coverage or $50. So how does this work when we're talking about the payout? Because when we're talking about the amount of coverage, the limit is the $50,000. If you bought $100,000, which is the amount that would be the death benefit if you died, but the premium is $100, then of course we can use the ratio and say, well then it looks like 50% of that $100, $50 was over the threshold and therefore the taxable component that would be included in say your W-2 line one adding to your taxation possibly. So prepaid life insurance. Some life insurance plans allow the policy holder to pay lump sum premium upfront. That money gets applied to the plan's premiums through the plan's duration. So the lump sum payment also grows in value because of interest. The growth of that money is considered interest income by the IRS, which means it can be subject to taxation when it is applied to a premium payment or when the policy holder withdraws some or all of the money they have earned. So if you've got kind of this cash component of the life insurance in some ways, then you would think that the money that you put in, if you didn't get like a tax benefit when you put the money into the insurance, which is now acting to some degree as investment, you might get some tax deferral benefit, at least tax deferral benefit on the growth, the interest in the cash value and that growth value you would think might be subject to taxed at some future point when used in some way, so you get the deferral component. So cash value plans. So many whole life insurance plans in addition to providing the insured with a fixed death benefit also accumulate cash value as policy holders pay into the plans with their premium dollars. A portion of the premium dollars enters a fund that accumulates interest. So you put money in, it's used kind of like an investment in some ways and you get a benefit because you're not paying taxes when it earns the interest, but now you've got this money that some of which has earnings on it, which you would think might be subject to taxes in some cases. So it is common particularly with plans that have been in force for many years for the cash value to exceed the amount the policy holder has paid in premiums. People use this type of life insurance as an investment vehicle along with taking advantage of the protection it provides their families in the event of an untimely death. So we're using it for two kind of purposes here, investment and for the life insurance. Many financial advisors remain steadfastly against using life insurance for investment purposes claiming the returns historically have been extremely weak compared to mutual funds and other investments. So we've discussed whether or not it's wise to take this strategy and not do the old adage which is simply buy just life insurance term life insurance and invest the difference. So you always want to be comparing back to that old adage. Nonetheless, the fact remains that the cash value of most whole life insurance policies grow over time because this is considered income to the policy holder. It has income tax implications. So now you've got this growth component that has income tax implications because if it was outside of the insurance and not under the umbrella of an IRA or 401K plan, then it would be subject to taxes. If you have interest income, you get a 1099 for it or dividend income. So the tax consequences, the good news for a whole life policy holder is they don't have to pay income taxes each year on the growth in their plans cash value. So you get that deferral kind of component at least similar to retirement accounts such as 401K plans and iras. The accumulation of cash value in a whole life insurance policy is tax deferred. Even though this money qualifies as income, the IRS does not require a policy holder to pay taxes on it until they cash out the policy, which is nice because again, you at least get that deferral. So if and when a policy holder elects to take the cash value of their whole life insurance policy, the amount they are required to pay taxes on is the difference between the cash value they receive and the total they paid in premiums during the time the policy was enforced. With for example, they pay $100 per month for 20 years or $24,000 and then cash out the policy and receive $30,000. The amount subject to tax would be the $6,000 that being of course the difference which we assume to be the growth which we didn't have to pay taxes on when we earned it within the policy as we would if it was outside the policy and some other investment savings account, for example, that's not under the umbrella of a tax shelter like or tax savings account like an IRA or 401k where we would have received a 1099 interest INT in that case. Another feature of whole life insurance is that in many cases the policy holder is allowed to take out a loan against the cash value of the policy. So we might say, well, I don't want to pay on that $6,000. Is there any way I can get the money out and not pay taxes? Well, maybe you could take a loan against it, but then you'd have to pay interest on it using the cash value as collateral. So there is a misconception that the proceeds for this kind of loan are taxable. That is not the case even when the loan amount exceeds the total premiums paid into the policy. So when our life insurance premiums tax deductible, life insurance premiums are not usually tax deductible. You may, however, be able to deduct them as a business expense if you are a business owner who has purchased life insurance coverage for key employees as part of a buy sell agreement. So typically when you're buying life insurance, it's not something that you will generally get like a deduction for, which is different than you might say, well, I get a tax benefit for putting money into like an IRA, for example, or something like that. Is there something similar for the life insurance, not generally speaking? So also if you were divorced prior to 2019 and have a court ordered life insurance policy, these premiums may also be deductible in some cases. Our life insurance death benefits taxed. Life insurance provides beneficiaries with the death benefit income tax free. So then when the, when you, if someone was dying within the term, then the beneficiary would get the death benefit, the payout of the life insurance company. And you would think, well, is that taxable because that could be significant. And generally that is not taxable. And that, that's huge. That's a good, that's nice. However, it may be subject to a state tax if the combined value of the state, including death benefits exceeds the tax threshold. So when we say it's not tax, we're usually talking like income taxes. Then you got a whole nother set of taxation thresholds with regards to a state taxes, which would be applicable if your state is over a certain threshold. And that if that's the case, then you might need to go into more complex tax planning strategies to try to stop the IRS from picking your pockets and doing the cavity search to find any wealth that you might have hidden somewhere. So our withdrawals from permanent life insurance taxed. So cash value life insurance has certain tax advantages. One of them is the withdrawals made from the policy are considered a return of premiums already paid and are therefore not subject to taxation. However, if you withdraw all of the value of the premiums you paid in and you begin withdrawing gains from interest or dividends, those dollars would then be taxed as income. So when you take money out, for example, you might have to question, okay, you're saying, okay, well, if I have this money that's kind of going to be the investment component of my life insurance part. And some of it are just part of the premiums that I put in. And then I earn say interest on top of it. And then I draw money out. The interest portion of it is the amount that you might think might be subject to taxes. So the question is, when I pull money out, can I count that as not the interest portion, but really the amount that I put in my original investment. And therefore it's not the growth part and therefore not subject to taxes. If you could do that, that's a tax advantage type of situation generally. So what's the bottom line? Life insurance premiums are not usually subject to sales tax. And they are also not tax deductible under most cases. So there are, however, certain circumstances where the IRS will treat life insurance premiums differently and you will face certain tax consequences. These cases most often arise when a business owns or pays for the life insurance policy.