With certain limitations, life insurance premiums can be deducted on bankruptcy’s means test. Since the means test determines whether you are eligible to file Chapter 7 bankruptcy or, if you are filing under Chapter 13, the amount you must pay into your Chapter 13 plan, be able to deduct life insurance premiums may be to your advantage when you file for bankruptcy.
Read on to learn how life insurance premiums can help you pass the means test, and what types of life insurance premiums are allowable deductions in bankruptcy.
What Is the Means Test?
The means test was developed by Congress to prevent people who are able to repay creditors under Chapter 13 bankruptcy, from filing for Chapter 7 bankruptcy. If your income exceeds the median income in your state based on your household size, you need to take the means test to find out whether you can file for Chapter 7.
How the Means Test Works
In the means test, you start with your disposable income and then deduct certain allowed expenses. If the result is over a certain amount, you are not permitted to file for Chapter 7, and instead must file for Chapter 13 bankruptcy. (To learn the difference, see What Is the Difference Between Chapter 7 and Chapter 13 Bankruptcy?)
In Chapter 13 bankruptcy, you must undergo a slight variation of the Chapter 7 means (deducting certain expenses from your income). The result plays a role in how much your Chapter 13 plan payment will be and how long your plan will last (three or five years).
The Role of Deductions in the Means Test
Deductions are important in the means test. The more allowable deductions you have, the more likely you’ll be able to qualify for Chapter 7. Similarly, if you are filing for Chapter 13 bankruptcy, more deductions may help you lower your plan payment or shorten the length of your plan.
(To learn more about the means test, how it works, and why it’s important for Chapter 7 and Chapter 13 bankruptcy, see Bankruptcy’s Means Test.)
Why the Life Insurance Deduction Is Important
Life insurance is one of the few areas on the means test where you can apply a deduction for an expense that is not necessarily required for day to day living. If you are planning to file a Chapter 7, you will want to claim any deductions you can to maximize your eligibility. If you are filing a Chapter 13 bankruptcy, taking all allowable deductions will lower the amount of your plan payments by an amount equal to the price of the premiums.
If you are planning to contribute 100% of your disposable income to the Chapter 13 plan for the next three to five years rather than putting money away for contingencies, safeguarding your family by maintaining a life insurance policy may take on added significance. Taking advantage of the life insurance deduction will allow you to pay for the policy with money that would have otherwise gone into a Chapter 13 plan to pay creditors.
Which Insurance Premiums Are Eligible for Deduction?
When filing for bankruptcy, if you manipulate your finances to avoid paying creditors, you’ll run into trouble. However, you are allowed to take reasonable measures to provide for your family. What this means in the life insurance context is that some types of premiums can be deducted, and others cannot. Here’s what’s permitted.
Insured Limited to Debtor and Joint Debtor
On the means test, you may deduct life insurance premiums for insurance on your own life. You may deduct premiums for insurance on your spouse’s life only if your spouse is filing for bankruptcy jointly with you. If your spouse is not filing, you may not deduct any premiums you pay for life insurance on your spouse’s life. You also cannot deduct premiums that you pay for insurance on the lives of any of your dependents.
Term v. Whole Life Policies
You can deduct premiums you pay for term life insurance. However, on the means test you may not deduct whole life policy premiums.
Term life policies are generally less expensive and do not build up cash value. You pay only for insurance benefits and if you stop paying, even for a short time, the policy is generally cancelled and any premiums paid are not recoverable. Whole life policies are different in that they are often seen as an investment rather than just an insurance policy. With whole life, you build up cash value in the policy that can be used to borrow against or may be cashed out if you choose to cancel the policy. As a result, the premiums are usually much higher than term life premiums. (To learn more about term and life insurance, see Life Insurance Options.)
Only the lower term life premiums are deductible on the means test.
Life Insurance Premiums as Part of the Marital Adjustment Deduction
If your spouse is not filing for bankruptcy with you and your non-filing spouse has their own income, any life insurance premiums that they pay from their own income may be allowed as part of the marital adjustment deduction. This deduction may be allowable without regard to whether the premium is for a term or whole life policy or who the insured is. (Learn more about how the marital adjustment deduction works in bankruptcy.)