Life insurance is one of a number of tools you can use to plan for the well-being of your beneficiaries after your death. You can buy life insurance directly from a provider, but some employer plans allow you to buy life insurance as well. The deductibility of your premium payments depends on how you pay for the life insurance policy.
Life Insurance vs Annuity
An annuity makes periodic cash payments for a set period or for the rest of your life. Annuities normally carry a death benefit, which is a lump sum payment to your beneficiary after you die. Whole life insurance policies can take the form of annuities, but term policies simply shell out a death benefit without making annuity payments. You can hold annuities and life insurance policies within an employer plan, but the Internal Revenue Service bars life insurance policies from IRAs.
Insurance in Qualified Plans
An employer-qualified retirement plan allows employees and employers to make tax-deductible contributions and enjoy tax-deferred growth. Qualified plans permit a limited amount of life insurance. Plans containing term or universal life insurance policies allow up to 25 percent of contributions to pay for insurance. However, up to 50 percent of contributions can pay for whole life insurance. These limits don’t apply after you've held the plan for five years. Your employer can deduct its entire contribution to your plan and you might receive a partial deduction on the insurance premium.
You must include in taxable income the value of the pure insurance protection you receive in an employer plan. Calculate this amount by multiplying the death benefit by the one-year rate of a comparable term insurance policy. These taxable amounts create the cost basis of your policy. You exclude any premiums above this amount from your taxable income, in effect making that portion tax-deductible because you deduct the contributions that pay for the premiums.
Other Tax Considerations
Because you can’t deduct life insurance premiums for non-qualified policies, your beneficiaries receive the death benefit tax-free. The IRS taxes a part of the death benefit from a qualified insurance policy. The taxable part is the amount in excess of the policy’s cost basis. You must cash in or distribute your qualified life insurance policy when you retire. If it’s distributed, you’ll pay tax on the policy value that exceeds the cost basis. If you cash in the qualified policy and you’re younger than 70 1/2, you can roll the money into an IRA and postpone taxes until you withdraw the cash. You can't roll over the cash from a nonqualified policy. Finally, you can pay the policy’s cash value to the employer plan’s trustee to purchase the policy, at which point it becomes a nonqualified policy.
- Idaho Department of Insurance: Consumer Tips in Purchasing Life Insurance or an Annuity
- Cannon Financial: Planning Ideas—Life Insurance in a Qualified Plan
- AccountingWeb: Strategies for Utilizing Permanent Life Insurance in Qualified Plans
- Internal Revenue Service: Publication 590 Individual Retirement Arrangements
- Ameriprise Financial: Tax Planning Tips: Life Insurance
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.