Tax Strategies for Donating Life Insurance

You invested in a permanent life insurance policy—which, unlike term life insurance, lasts your lifetime rather than a set period—to help secure your family's future. But with your children grown, your mortgage paid off, and your retirement on track, what if you decide you no longer need it?

You could surrender the policy for its cash value, but doing so would trigger ordinary income taxes on the policy's appreciation. Donating a policy, on the other hand, can help sidestep this burden and turn its surrender value into a powerful charitable gift.

"Many people don't think of a permanent life insurance policy as an asset, but it is," says Austin Jarvis, director of estate, trust, and high-net-worth tax at the Schwab Center for Financial Research. "By donating it to a 501(c)(3) public charity, you can help make a lasting impact on a cause you care about, as well as potentially receive an immediate tax benefit and possibly reduce your estate taxes down the road."

Depending on your tax situation, you can donate your policy using one of these approaches:

You make an irrevocable transfer of the policy to a charity, which generally allows you to eliminate any taxes and claim a current-year tax deduction if you itemize. "This could be a strategy to use in a year in which you have unexpectedly high income," Austin says. Your deduction is limited to the lesser of the policy's cash value or the cost basis (generally, premiums paid to date). The charity, in turn, can surrender the policy for its cash value and assume any related fees. Transferring ownership of the policy also removes it from your estate, potentially lowering or even eliminating future estate taxes.

Be aware, however, that the charitable tax deduction for a gifted life insurance policy is limited to 50% of your adjusted gross income for the year—though any unused portion can be carried forward for up to five consecutive tax years.

If you've borrowed against the policy, you may be subject to additional IRS rules regarding deductibility and taxation of the loan. In addition, to claim a deduction, a qualified appraisal may be required to substantiate the value. "The rules are complicated, so be sure to work with a tax advisor before making such a gift," Austin says.

You keep control of the policy and continue paying any premiums, with the charity receiving a payout upon your death. You can't claim a tax deduction during your lifetime, but your estate can claim one after you pass. And because you maintain ownership of the policy, you can change the beneficiary at any time. "This could be a good solution for those who have charitable goals but want the ability to alter their gifting strategy if circumstances call for it," Austin says.

If you use a donor-advised fund for charitable giving, you can transfer the policy to the fund during your lifetime, or designate the fund to receive the death benefit when you die. "That way the assets remain invested for potential growth to amplify your generosity," Austin says.

Your financial consultant or tax advisor can help determine the best option for your situation.