Life Insurance
Is Life Insurance Taxable?
By , Finance Writer & Licensed Insurance Agent
Updated: Sep 5, 2023
Life insurance is not usually taxable but can be in some situations. The Internal Revenue Service (IRS) views the payout as a premium refund, which isn’t taxable. Thus, life insurance proceeds are usually not taxable for the beneficiary.
However, if you decide to sell your life insurance policy, exceed the federal estate tax exemption limit or if your beneficiary chooses to receive the death benefit in installments, there is a possibility that taxes may apply. Understanding when and how taxation on life insurance works can help you avoid taxes or plan for them.
Table of Contents
Key Takeaways
Life insurance payments are not taxable. In most cases, the death benefit passes to the beneficiary tax-free.
A beneficiary might have to pay taxes if a third party is the policy owner or they decide to take the death benefit in installment payments.
Your heirs could pay estate and income taxes if the life insurance payout causes the estate to exceed the federal guideline of $12.92 million.
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Life Insurance Taxation: How Does It Work?
Life insurance taxes can be triggered by some specific actions or events. How much life insurance is taxed depends on your circumstance and tax status. For example, you might be subject to taxes on your life insurance if there are more than two parties involved in the policy, if you make a cash value withdrawal or if you decide to sell or surrender the policy. But life insurance is not taxable for most beneficiaries, and neither are earned dividends.
There are several types of life insurance taxes you could end up paying as a beneficiary. Estate tax, inheritance tax, income tax or generation-skipping taxes may cause beneficiaries to pay taxes on life insurance policies. The table below highlights scenarios that can make life insurance taxable income and the tax type levied.
Types of Taxes Levied on Life Insurance Policies
Type of Tax | Description |
|---|---|
Income Tax | If you sell your life insurance policy, you’ll pay income tax on the profits that exceed the policy basis, which is either the purchase price of the policy or the paid premiums. Buying a terminally ill person’s life insurance policy as a viatical settlement can help you avoid income tax, but you must meet strict guidelines. State guidelines may differ and can change yearly, so be sure to work with a licensed life settlement provider if you want to buy a viatical settlement. |
Capital Gains Tax | On top of income tax, you could also pay capital gains tax on a life insurance payout if you sell the policy. For instance, if the cash value life insurance total is larger than the policy basis, you’ll pay capital gains tax on the difference. If you plan to buy another life insurance policy, you could avoid capital gains tax by replacing it as part of a 1035 exchange. |
Estate Tax | If the value of the death benefit causes your estate to exceed the 2023 federal estate tax exemption limit of $12,920,000, your heirs will pay estate tax on the coverage in 12 states and Washington, D.C. This can happen even if you name a beneficiary that isn’t part of your estate. Although the beneficiary receives the death benefit tax-free, your other assets in the estate will be taxed. |
Inheritance Tax | In some states, you pay inheritance tax on life insurance proceeds if you exceed the exemption level. Iowa, Kentucky, Pennsylvania, Nebraska and New Jersey impose a 2%–16% inheritance tax. Maryland imposes estate and inheritance taxes. A life insurance payout to a spouse is typically exempt, and other immediate relatives are either partially or fully exempt, depending on the state. Beneficiaries handle inheritance taxes based on their distribution amount. |
Gift Tax | A gift tax assessment occurs on life insurance policies with three or more people. In most policies, the policy owner and insured are the same. But if they are two different people and neither is the beneficiary, the death benefit is considered a gift and subject to a gift tax. You can avoid gift tax on life insurance proceeds by ensuring only two people are involved in a life insurance policy. |
Generation-Skipping Tax | Some people with a high net worth may think they can avoid estate taxes by skipping a generation. For instance, this may involve a grandparent designating a grandchild as a beneficiary instead of their own child. However, the generation-skipping tax will still be enforced on assets that exceed the federal estate tax exemption limit. |
Factors Affecting the Taxable Status of Life Insurance
Several factors come into play, determining whether your life insurance proceeds will be subject to taxation. Understanding these factors can help you make informed decisions, ensuring you maximize the financial benefits while minimizing potential tax liabilities.
Death Benefit
Generally, death benefits are tax-free. However, if the payout accrues interest or inflates the value of an estate beyond federal exemptions, taxes may apply.
Premiums
Premiums paid on a life insurance policy with after-tax dollars are usually not deductible. Therefore, they don't typically affect the taxable status of the death benefit.
Cash Value
For permanent life insurance policies like whole and universal life, the cash value grows tax-deferred. Taxes may apply if withdrawals exceed the total premiums paid.
Access to Cash Value
Borrowing against the cash value is usually tax-free. But if the policy lapses or is surrendered with an outstanding loan, the loan amount could become taxable.
MONEYGEEK DICTIONARY
A life insurance beneficiary is the individual or entity designated to receive the death benefit from a life insurance policy when the policyholder passes away. Beneficiaries can be family members, friends, trusts or even charitable organizations. The policyholder has the flexibility to name multiple beneficiaries and specify the percentage of the death benefit each should receive.
When Life Insurance Is Not Taxable
Life insurance is not taxable when you receive dividends or take the death benefit as a lump-sum payout. We explain these two nontaxable life insurance situations below.
The death benefit is received in a lump sum
Taking the death benefit as a lump sum generally means it will be tax-free. For instance, if you are the beneficiary of a $100,000 term life insurance policy and don’t meet any of the criteria above for taxable events, you should receive the full $100,000 life insurance payout tax-free. You can then do whatever you want with the lump sum, including paying for the policyholder’s funeral, paying off debt, going on vacation, investing it or giving it to charity.
You receive dividends on a permanent life insurance policy
If you have a permanent life insurance policy, you could receive dividends at the end of the year. This occurs when the insurance company ends the year with a profit after paying all its expenses. The company can share some earnings with policy owners as a dividend. Since the IRS considers dividends to be premium refunds, they are not considered taxable income.
When Life Insurance Is Taxable
There are some situations when life insurance is taxable. Your life insurance payout is taxable if you meet estate or gift tax criteria, receive the death benefit in installments, withdraw over the policy basis or don’t repay a cash value loan. If you surrender or sell the policy, your life insurance is taxed for the amount exceeding the policy basis. We expand more on these taxable life insurance situations below.
You receive the death benefit in installments
Taking the death benefit in installments may seem like a smart move if you’re worried about having access to a lot of cash. Still, the interest you earn is taxable income. You may want to consult a financial advisor to help you decide how to spend, save or invest the lump sum to avoid paying income tax on the interest that accrues during the installment phase.
The death benefit causes your estate’s worth to exceed the limit
Even if your estate isn't the beneficiary of your life insurance policy, the death benefit amount is part of your net worth. For high-net-worth individuals, exceeding the federal estate tax limit means your heirs will pay estate taxes on the amount over the limit. The taxable amount is deducted from the estate assets and is not payable by the life insurance policy's beneficiaries.
There are more than two parties involved
In most cases, the insured and the life insurance policy owner are the same person. Typically, having distinct policy owners and insured individuals does not trigger a taxable event, unless the beneficiary is also a different person. For example, if a father owns a life insurance policy on his wife and names a child as the beneficiary, the death benefit qualifies as a gift and is subject to gift tax.
You withdraw from the policy
When you have a permanent life insurance policy, you build cash value. Once you’ve built up enough cash value, you can withdraw some funds to use however you like. But if the withdrawal is more than the policy basis-paid premiums minus dividends, the difference is subject to taxes.
You fail to repay your cash value loan
You can also take a loan out from the cash value of a permanent life insurance policy. Cash value loans are tax-deferred as long as the policy stays in force. But if you fail to repay it and the policy ends, whether it lapses or you surrender it, the loan amount that exceeds the policy basis is taxable income. If you die with a loan balance, the outstanding amount reduces the death benefit proceeds your beneficiary receives.
You surrender the policy
If you no longer need or want your cash value life insurance, you can surrender it to the insurer. You’ll receive the cash value minus the surrender charge, if applicable. You won’t have to pay taxes on the entire surrender value. You pay taxes on the life insurance cash-out investment gain, which is the amount over the policy basis.
You sell the policy
Selling a life insurance policy may subject you to both capital gains and income taxes on any profit above the policy basis.
Are Life Insurance Premiums Tax Deductible?
Paying premiums on life insurance is not tax deductible when you buy an individual policy. Like buying other insurance types, like home and auto, life insurance premiums are considered an ordinary life expense and therefore, are not eligible for a tax deduction. But if you’re a business owner who uses business funds to pay for coverage, life insurance premiums are tax-deductible as they are considered a business expense.
MONEYGEEK EXPERT TIP
Knowing how life insurance works can help you decide what type of life insurance to buy and how much coverage you need. Both permanent and term life insurance have different benefits and tax implications.
How To Avoid Paying Taxes on Life Insurance
There are a few ways to avoid taxes on life insurance proceeds, such as not overpaying premiums, taking a lump-sum death benefit and paying back cash value loans. We outline ways to avoid making life insurance taxable in the table below.
1
Get the death benefit as a lump sum
Taking a lump-sum death benefit means you avoid paying taxes on the income installment payments generated through interest. If you’re tempted by the lump-sum payout or aren’t sure how to best make your money work for you, consider working with a financial advisor. You can explain your goals for the funds, and the advisor will devise a solution to meet your goals and minimize a taxable situation.
2
Withdraw less than the policy basis
One perk of permanent life insurance is building cash value over time. Once you’ve gained a nice nest egg, you might want to withdraw funds to pay bills or take your family on vacation. You can avoid paying taxes on the withdrawn amount by taking out less than the policy basis. Your insurance company can let you know the policy basis amount so you know your withdrawal limit.
3
Don’t overpay your premiums
Some people pay more than their premium amount to build cash value faster. But if you overpay your premiums by too much, your life insurance policy becomes a modified endowment contract, or MEC. If this happens, you pay income tax on cash value withdrawals, even if the amount is lower than your policy basis.
4
Pay back your cash value loan
Another advantage of a cash value life insurance policy is being able to take out a loan instead of withdrawing the amount. If you take out a loan, it’s best to repay it. Not only does it accrue interest, but you could end up paying taxes on the loan amount if you fail to pay it back and the policy is canceled. Instead, work on paying back the loan as soon as you can, which can also help avoid reducing your beneficiary’s payout if you die before it’s paid back.
5
Transfer ownership to an irrevocable life insurance trust (ILIT)
High-net-worth individuals can avoid their heirs paying taxes on life insurance by transferring the policy ownership to an irrevocable trust. Once you establish an irrevocable trust, you can’t change it. This option is a way to protect assets from creditors, estate and gift taxes. Setting up a trust can be difficult, so we recommend working with a knowledgeable financial advisor.
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Frequently Asked Questions
Life insurance is taxable in some situations. Find the answers to the most frequently asked questions about life insurance taxation below.
Expert Advice on Life Insurance and Tax Deduction
- How often should you review your life insurance coverage to determine if changes may need to be made due to changing financial circumstances that could impact its status as a deductible?
- What is the best way to ensure that you are taking advantage of all possible deductions when it comes to life insurance premiums?
- Are there any strategies or techniques an individual can utilize in order to maximize their potential tax deductions related to life insurance?
Ann Murphy
Professor of Law at Gonzaga University
Stephanie G. Wendling
CPA, CFP®, MSTFP, Instructor at Widener University
Learn More About Life Insurance
About Mandy Sleight, Licensed Insurance Agent
sources
- Internal Revenue Service. "Estate Tax." Accessed September 1, 2023.
- Internal Revenue Service. "Life Insurance & Disability Insurance Proceeds." Accessed September 1, 2023.
- Tax Foundation. "Facts & Figures 2023: How Does Your State Compare?." Accessed September 1, 2023.