How Life Insurance Can Reduce Your Taxes

By Richard McGrath, CIC, LIA

Life insurance can serve many purposes, but there’s one use you may not be aware of – it can reduce your taxes.

Cash-value life insurance, also known as permanent life insurance, can not only reduce your taxes while you’re living, it can protect your heirs from both income taxes and estate taxes, so that your wealth is transferred to your loved ones, rather than to the government.

Like a qualified retirement plan, such as a 401(k) plan, you can also use life insurance to build cash value on a tax-deferred basis.  The cash that builds up in your insurance policy does not become taxable as income until you withdraw it from your insurance account.

As with a 401(k) plan, your cash value will be invested and will continue to earn money, but there are no limits on how much you can invest in life insurance.  Earnings are reinvested continuously without being subject to taxation, so you can take full advantage of compounding.

If you don’t use the cash value in your insurance policy and it passes on to your beneficiaries, they will owe no federal or state income taxes on it.  That’s an advantage that life insurance has over retirement plans, IRAs and tax-deferred annuities.  When your heirs inherit your unused retirement savings, they will owe income taxes on their inheritance; when they receive the “death benefit” from your life insurance policy, they will owe no federal or state income tax on it.

In addition, the benefit from your life insurance policy will not be used when calculating taxes on your Social Security income.  All other income, including income from retirement plans is included when calculating the tax.  The higher your income, the higher your taxes will be, so excluding income from life insurance can lower your taxes.

Federal income tax rates range from 10 percent for those earning $9,075 or less ($18,150 for married couples filing jointly) to 39.6 percent for those earning more than $406,750 ($457,600 for married couples).  The Massachusetts income tax rate is 5.2 percent, so receiving a death benefit from life insurance instead of income from other sources can save your heirs living in Massachusetts as much as 44.8 percent of the total.

There are rare exceptions where benefits from a life insurance policy are taxable as income.  If a life insurance policy is transferred to someone else for a “valuable consideration” (i.e., if it is sold in exchange for money today) the death benefit becomes taxable.

The exclusion from income tax also does not apply if a life insurance policy is combined with a non-refund life annuity where a single premium equals the face value of the insurance.  Assuming the beneficiary receives monthly payments and interest received exceeds the face value of the life insurance, the excess interest will be taxed as income.

Minimizing Estate Taxes

Avoiding income taxes is a great benefit, but not if you end up paying estate taxes on your life insurance benefit, as the top federal estate tax rate is 40 percent and the Massachusetts estate tax rate can be as high as 16 percent.

Most residents are exempt from federal estate taxes, as taxpayers can receive a credit for assets worth up to $5.34 million and the amount is indexed for inflation.  In Massachusetts, though, assets exceeding a total value of just $1 million are subject to estate taxes.

Life insurance proceeds are subject to the estate tax if the deceased is the owner of the policy at the time of death.  However, estate taxes can be avoided if a trust is established and is set up as the owner of the life insurance policy.  If you own life insurance and transfer ownership to a trust, the trust must own the policy for at least three years before your death; otherwise, you will still be considered to be the owner.

Here’s an example of how it works.  You and your spouse set up an irrevocable life insurance trust, then make a cash gift to the trust to purchase a permanent survivorship life insurance policy.  Your spouse can inherit the life insurance benefit without it being subject to estate taxes, but when the surviving spouse dies and it is passed on to heirs, it would typically be subject to estate taxes.  If the death benefit is owned by the trust, though, it can be passed on to heirs without being subject to either estate or income taxes.

What if you want to benefit your heirs while you are still alive?  You can give your heirs gifts of up to $14,000 each with cash from your life insurance policy while you are still alive without your gifts being subject to the gift tax.  The unified tax credit allows you to gift up to $5 million in assets over your lifetime without your gifts being subject to the gift tax or estate taxes.

If your heirs then use part of the gift you provide to purchase insurance on your life, they can still collect a death benefit, but also take advantage of your gift while you are still living.

A Tax Benefit for Employers

Life insurance can also provide a tax benefit to employers.  While life insurance premiums are not tax deductible for consumers, employers can deduct premiums for group term life insurance as a business expense.  While there are no limits on the amount of coverage that can be provided, benefits plans must pass tests to ensure that the plans are not weighted to favor key employees.

Employees also receive the insurance tax-free, up to the first $50,000 of coverage.  The value of coverage exceeding $50,000 is considered taxable income and employees who receive the insurance must pay a tax based on IRS tables.

Life insurance can protect your family and ensure that your spouse and children are taken care of if something happens to you.  That is its most important purpose, but it’s good to know that it can also provide tax advantages that no other insurance product or investment can provide.

Richard A. McGrath, CIC, LIA is President and CEO of McGrath Insurance Group, Inc. of Sturbridge, Mass.  He can be reached at

This article is written for informational purposes only and should not be construed as providing legal advice.