Life insurance policies are a way to financially protect your loved ones after you pass away.
But will your beneficiaries owe taxes on the life insurance payout?
Usually, no, you don’t have to pay taxes on life insurance payouts. But like most general rules, there are a few exceptions.
We’ll break down some situations when you or your beneficiaries may owe taxes on life insurance along with tips to avoid a big tax bill.
Is Life Insurance Taxable?
In most cases, life insurance policy proceeds are not taxable. When your beneficiaries receive a death benefit — the payout from the insurance company — it’s generally considered a non-taxable event.
If your life insurance policy pays out the death benefit in a single lump sum, your beneficiaries will receive the full amount specified in the policy, free from any income tax obligations.
That’s because the IRS doesn’t view life insurance payouts as taxable income.
Certain insurance companies offer riders called accelerated death benefits, which allow policyholders to access part of their policy’s death benefit while they’re still alive. If your policy features this type of rider, you can also receive funds from the life insurance policy without having to pay income taxes.
4 Situations When Life Insurance Proceeds Can Be Taxable
While life insurance payouts are generally tax-free, there are a couple specific circumstances where taxes may come into play.
1.Payouts Are Distributed in Installments
Most people choose to receive a life insurance payout in a single lump sum. However, some people choose to have their life insurance proceeds spread out over time, creating an annuity.
When a life insurance payout is distributed to your beneficiaries in installments with added interest, the interest portion may be subject to income tax. You don’t have to pay taxes on the principal amount though.
Here’s an example.
Your beneficiary chooses to receive their $1 million life insurance payout in monthly installments over 10 years at a 5% interest rate.
The $1 million payout won’t be taxable, but any interest accumulated during the 10-year period will be subject to their ordinary income tax rate.
2. The Death Benefit Becomes Part of Your Taxable Estate
If the death benefit from your life insurance policy becomes part of your estate, it may be subject to estate tax.
This can happen if you made the policy “payable to my estate,” a beneficiary wasn’t named on the policy or the named beneficiary died before you.
Most people don’t have to worry about estate taxes. Your estate must be worth a substantial amount — $12.93 million in 2023 — to trigger federal estate tax. And the entire estate isn’t subject to taxation, just the portion that exceeds $12.93 million.
In this situation, if your life insurance death benefit adds to the value of your estate, it could potentially be subject to estate taxes. Similarly, if you’re near the cusp of owing estate taxes, a $1 million policy may be enough to push you into the taxable zone.
Seventeen states also levy their own estate taxes, sometimes with lower limits. In Oregon, for example, estate tax kicks in after $1 million.
You won’t personally have to pay estate taxes. Instead, taxes are paid from the assets of your estate and the executor of your will is in charge of filing the appropriate estate tax forms.
An easy way to avoid all this is to name a beneficiary on your life insurance policy and keep that information updated over time.
You can also name contingent and secondary beneficiaries. If your primary beneficiary passes away, there’s still a backup who can receive the life insurance death benefit tax-free.
3. Three Different People Are Named on the Policy
If you have a life insurance policy and three different people are involved — the insured, the policy owner and the beneficiary — things can get a little tricky with taxes.
Let’s break it down a bit.
The insured is the person whose life is covered by the policy. The policy owner is the one who buys the policy. And the beneficiary is the person who gets the life insurance proceeds if the insured person passes away.
Usually, it’s just two people involved, like you buying a policy for yourself and naming your child as the beneficiary.
But if three people are involved, the IRS sees it as the policy owner giving a gift to the beneficiary, and that means you might have to pay gift tax on the life insurance proceeds.
For example, if you buy a policy to cover your spouse’s life, and your child is the beneficiary, the IRS sees it as a gift from you (the policy owner) to your child (the beneficiary). That means you might be on the hook for gift tax because you’re considered the donor.
You (as the policyowner) may have to pay gift tax for the life insurance payout that exceeds federal gift tax exemption limits. In 2023, the annual gift exclusion is $17,000 per person and the lifetime limit is $12.93 million per person.
To avoid any tax implications, it’s best to keep it simple. Stick with two people on the policy. That way, you steer clear of the gift tax mess.
4. You Sell Your Life Insurance Policy to a Third Party
If you sell your life insurance policy to a third party through a process known as a life settlement, the proceeds may be subject to taxation.
Some of the money you receive from a life settlement may be taxed at either your ordinary income rate or the capital gains tax rate.
Here’s how it works.
The amount received from a life settlement is tax-free up to the premiums you’ve already paid into the policy. This is called your cost basis.
Let’s say you’ve paid $10,000 in premiums since you bought your policy. If you sell it for $20,000, the first $10,000 of that sale isn’t taxable.
After that, the amount up to your policy’s cash surrender value is taxed at your ordinary income rate. The rest is taxed at the capital gains tax rate.
The settlement won’t be taxed at all if proceeds are less than the premiums you’ve paid into the policy.
Generally, viatical settlements are spared from taxation. A viatical settlement is a specific type of sale only available to terminally ill policy owners who have less than two years to live.
If you receive IRS Form 1099-LTC after selling your policy, the proceeds are usually tax-free.
Taxation of life settlements can get really complicated. It’s best to consult a financial advisor or tax expert prior to selling your policy so you can fully understand the tax implications.
Taxation of Cash Value in Whole Life Insurance Policies
Whole life insurance policies offer a cash value component that accumulates over time. Part of your premium payments go to the insurance company and a portion of the premium payments enter a fund that accumulates interest.
As the cash value grows in a permanent life insurance policy, you can choose to withdraw money.
Withdrawals made from the policy are considered a return of premiums you’ve already paid, so that money isn’t subject to taxes.
But if you withdraw all of the premiums you paid in as well as gains from interest or dividends, some of that money is subject to income taxes.
While the death benefit remains tax-free for your beneficiaries, there are a few situations when you might owe income taxes on the policy’s cash value.
Surrendering the Policy
Surrendering a life insurance policy is basically the same as canceling it.
If you surrender your whole life policy to the insurance company and receive the cash value as a payout, you’ll be taxed on the amount you received minus the policy basis, or the total premium payments you made on the policy.
That’s because this excess amount is considered a taxable gain.
For example, you’ve paid $25,000 in premiums on your $1 million whole life policy. Over the last 10 years, the cash value grew $5,000. If you cash out $30,000, you’ll need to pay income taxes on the $5,000 earned from interest.
Taking Out a Loan Against Cash Value
You can take out a loan from the value of your whole life insurance policy and you don’t have to pay taxes on those loan proceeds.
However, if the policy lapses or is surrendered with an outstanding loan balance, the amount exceeding the total premiums paid may be taxable.
This can happen if the interest on the loan becomes greater than the policy’s cash value. When this happens, the insurance company can cancel the policy, leaving you with a tax bill.
Frequently Asked Questions (FAQ)
Are Life Insurance Premiums Taxable?
No, life insurance premiums aren’t taxable. The money you pay toward your policy is usually made with after-tax dollars, meaning you’ve already paid taxes on that money. That’s why life insurance premiums aren’t tax deductible on your yearly tax return either.
Is Group Life Insurance Taxable?
If your employer subsidizes some or all of the cost of your group life insurance policy, you may be subject to taxes.
However, taxes only apply when the employer pays for more than $50,000 in life insurance coverage.
Your tax obligation hinges on the cost of the group life coverage beyond that $50,000 threshold.
Here’s an example.
Your employer-provided life insurance coverage amount is $100,000. The premium payments that go toward the first $50,000 in coverage are not taxable, but premium payments that go toward the other $50,000 (the amount above the IRS threshold) are taxed as income.
So, if your monthly premium is $100, then $50 of that payment would be taxable.
Your employer will include the cost of the excess coverage in your reported wages. You’ll be able to see this information on your paystubs, and when tax season rolls around, it will appear on your annual W-2 form.
Are Life Insurance Dividends Taxable?
Life insurance dividends are typically not taxable as long as they are classified as a return of premiums or a reduction in future premiums. These dividends are considered a refund or credit rather than income.
However, if the dividends earn interest or accumulate value, that additional amount may be subject to income taxes. This can happen if the dividends are held in an interest-bearing account.
Rachel Christian is a Certified Educator in Personal Finance and a senior writer for Codetic. She focuses on retirement, life insurance, investing and taxes.