Why Insurance And Taxes Are Important To Your Financial Health

Investing
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By Steven Podnos, MD CFP

Learn more about Steven on NerdWallet’s Ask an Advisor

I don’t think that most people think about the relationship that insurance and taxes have, but this information can be important to your financial health.  Let’s look at how these factors affect each other in several different categories.

Life Insurance

In most cases, the receipt of a death benefit is not subject to income taxes.  The exceptions to this rule exist when an insurance policy has been sold or transferred under specific circumstances.  For the overwhelming majority of people owning life insurance with their spouse or dependents as beneficiaries, income tax on the benefit is not a concern.  Some insurance policies have a savings component (cash value, whole life, universal life, variable life) which may result in an income tax liability. For example, if a policy with a cash value is terminated prior to death, and the cash value (including any loans) is greater than the sum of all the premiums paid in -the difference is taxable as ordinary income.

Life insurance and estate taxation is a completely different subject.  The cash value of a policy owned by someone is taxed as an asset at the time of their death.  The death benefit is taxed in an estate if the decedent owns the policy or if the beneficiary is the estate itself.

In many cases, life insurance is owned outside an estate in an “irrevocable life insurance trust” or ILIT.  This allows a policy to pay heirs with no consequences of either estate or income taxation.  An alternative is to have heirs as owners and beneficiaries of a life insurance policy, but this does not offer t the control aspects of a trust.

Life insurance premiums are almost never a tax deductible expense.  In certain cases, there are sophisticated “split-dollar” plans that large companies use to retain and attract executives which involve some degree of pretax insurance premiums, but these are usually under close scrutiny by the IRS.  If a business buys “key person” insurance on a valued employee, it may deduct the premiums, but then the benefit is a corporate asset as well.

Property/Casualty Insurance

In almost every usual case, the receipt of a payment for a loss from your automobile or homeowner’s coverage is not a taxable event.  In the unusual circumstance in which you receive payments exceeding the loss, the “profit” could be considered taxable income.

Many type of property casualty insurance premiums are tax deductible when related to a business.  Homeowner’s insurance is almost never tax deductible.

Property casualty insurance related to rental and other business property is deductible by the business.

Health Insurance

Health Insurance benefits are almost never taxable.  Health Insurance premiums are fully deductible by self employed individuals up to the amount of their net income.  Employers may deduct health insurance premiums as a business expense only if a certain percentage of employees are covered as well.

High deductible health insurance plans allow contributions to a Health Savings Account.  The HSA is the only legal way to totally avoid taxes on income.  Deposits are made pre-tax, grow tax free, and can be used without any tax liability for a wide variety of health care expenses.

Long Term Care Insurance

Long Term Care benefits are almost never taxable.  Premiums for this insurance (if considered “tax qualified” as most policies are) are fully deductible (with certain limits based on age) for many individuals and self employed parties. C Corporations may also fully deduct the cost of LTC insurance for their employees.

Understanding the tax aspects of all the various types of insurance you purchase is an important aspect of being financially successful.