Is Life Insurance Taxable?

Name: Is Life Insurance Taxable?
Item: Is Life Insurance Taxable?
Author: Mandy Sleight

In most cases, life insurance proceeds received as a beneficiary upon the insured's death are not considered taxable income and do not need to be reported. However, any interest earned on those proceeds is taxable and must be reported as interest income.

By Mandy Sleight

Edited by Myjel Guevarra

Contributions by 5 experts

Updated: November 20, 2024

Advertising & Editorial Disclosure

Life insurance is not usually taxable but can be in some situations. The Internal Revenue Service (IRS) often considers the death benefit a premium refund, which is not taxable. Thus, life insurance proceeds are generally not taxable to the beneficiary.

However, life insurance taxation can occur in certain scenarios. 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

How Life Insurance Taxation Works
Are Premiums Tax Deductible?
How to Avoid Being Taxed
Frequently Asked Questions

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 $13.61 million.

Do You Pay Taxes on Life Insurance?

Specific actions or events can trigger life insurance taxes. How much life insurance is taxed depends on your circumstance and tax status. For example, life insurance tax may apply if your policy involves more than two parties, you make a cash value withdrawal or you decide to sell or surrender the policy. But life insurance is not taxable for most beneficiaries, and neither are earned dividends.

You could end up paying several types of life insurance taxes 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 on Life Insurance Payouts

Type of Tax	Description
Income Tax	Selling your life insurance policy may lead to income tax on life insurance profits exceeding 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 l policy, you could avoid capital gains tax on life insurance payout by replacing it as part of a 1035 exchange.
Estate Tax	Suppose the value of the death benefit causes your estate to exceed the 2024 federal estate tax exemption limit of $13,610,000. In that case, 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.
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 1%–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 on life insurance payouts based on the 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 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 influence whether life insurance is taxable or not. Understanding these factors can help you make informed decisions, maximizing the financial benefits while minimizing potential tax liabilities.

Death Benefit

Generally, life insurance death proceeds are tax-free. However, if the payout accrues interest or inflates the value of an estate beyond federal exemptions, taxes on life insurance benefits 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 on life insurance cash out 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 Is Life Insurance Not Taxable?

Life insurance offers certain non-taxable benefits under specific conditions, such as receiving dividends or taking the death benefit as a lump-sum payout. Here are details on the two primary scenarios where life insurance is tax-free:

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 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.

Awareness of these nuances allows policyholders and beneficiaries to navigate their financial decisions with greater insight and efficiency, ensuring they derive the maximum life insurance tax benefits.

When Is a Life Insurance Payout 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, interest on life insurance proceeds 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 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. Tax implications of cashing out life insurance may be triggered if the withdrawal is more than the policy basis-paid premiums minus dividends. In such cases, 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 cash surrender value of life insurance. 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.

You receive dividends

Dividends are generally not taxable when considered a return of premium. However, there are instances when dividends paid from a life insurance policy are taxable. If you leave the dividends in your policy to accumulate interest, they are not taxable, but any interest earned on those dividends is taxable.

These scenarios highlight the importance of understanding life insurance and taxes, particularly in how specific actions can change the tax implications of life insurance benefits.

IS COMPANY-PAID LIFE INSURANCE TAXABLE?

Tax implications on company-paid life insurance, often provided as a group benefit, depend on the amount of coverage. The premiums paid by the employer for coverage up to $50,000 are not taxable to the employee. If the life insurance coverage exceeds $50,000, the IRS requires the cost of the excess benefit to be reported as income, making it taxable to the employee. This is known as "imputed income" and reflects the cost of insurance the employer paid for coverage that exceeds the tax-exempt threshold. Life insurance payments are not taxable if the employee pays premiums in after-tax dollars.

Is Life Insurance 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. However, some exceptions and nuances to be aware of, such as business-related life insurance expenses and accelerated death benefits, can make your life insurance premiums tax deductible.

Business-Related Life Insurance: If you purchase a policy to protect the financial stability of a business and the business is the policy beneficiary, the life insurance payments may be tax deductible. This deduction is recognized because the insurance is deemed a necessary business expense to safeguard against financial losses that could arise from the death of a key employee or owner.
Employer-Paid Premiums: Premiums paid by employers on life insurance policies for employees are generally deductible as a business expense. However, if the policy's coverage exceeds $50,000, the cost of the excess coverage is treated as imputed income to the employee and becomes taxable. This imputed income is considered a life insurance taxable benefit and must be reported accordingly.
Charitable Contributions: When a life insurance policy is donated to a charity, the donor may deduct the cash surrender value of the policy at the time of donation. Subsequent life insurance payments may be tax-deductible. This arrangement not only provides a potential tax benefit to the donor but also benefits the charity upon the policyholder's death.
Accelerated Death Benefits: Premiums paid on life insurance policies that include accelerated death benefits are deductible if the policyholder is chronically ill, and the proceeds are used to pay for significant long-term care services. These payments are typically tax-free life insurance policy payouts and help alleviate the financial burden of long-term care.
Business Partnership Policies or Buy-Sell Agreements: The premiums of a life insurance policy might be tax deductible if you use the policy to fund buy-sell agreements. This setup ensures the business can continue smoothly by providing the funds necessary to buy out the deceased partner's interest, thereby avoiding potential financial disputes among surviving partners.

Each scenario underscores the importance of understanding the specific tax implications associated with life insurance premiums. Consider consulting with a tax professional to ensure compliance and optimization of potential tax benefits.

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 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 the lump-sum payout tempts you, or you 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.

By implementing these strategies, policyholders can effectively manage their policies to ensure that their beneficiaries receive the maximum benefits without paying taxes on life insurance payouts.

Frequently Asked Questions About Life Insurance and Taxes

Life insurance is taxable in some situations. Find the answers to the most frequently asked questions about life insurance taxation below.

When does life Insurance get taxed?

Life insurance is taxable when you fail to pay back a cash value loan and the policy cancels or you withdraw more than the policy basis. If the policy causes your estate to exceed the federal limit, you profit by selling or surrendering life insurance, taking installment death benefit payments or if three entities are involved.

When is life insurance tax-free?

Life insurance is not taxable if you receive dividends. The dividend payment is treated as a premium refund. Life insurance proceeds are also not taxable if you take a lump sum and the amount doesn’t make the decedent’s estate exceed the federal estate tax threshold.

Are life insurance premiums tax deductible?

Life insurance premiums are tax deductible for business owners who use company funds to pay premiums. For everyone else buying individual life insurance, premiums are not tax deductible. If you buy group life insurance and your employer pays some or all of your premium for coverage over $50,000, the employer’s portion may be subject to income tax.

How do you avoid paying taxes on life insurance?

You can avoid paying taxes on life insurance by taking the lump-sum death benefit, not overpaying premiums, paying back cash value loans and withdrawing on a policy basis. Putting the life insurance policy into an irrevocable trust allows high-net-worth individuals to avoid estate and gift taxes.

Do you pay inheritance taxes on life insurance?

Inheritance taxes on life insurance proceeds depend on state laws. Most states do not tax life insurance benefits, but six have inheritance taxes that could apply to beneficiaries. These are Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.

Is life insurance paid out in a lump sum?

Life insurance can be paid out in a lump sum or through various installment options, depending on the policy terms and the beneficiary's choice. A lump sum is generally the default payout method.

What happens if you don’t name a beneficiary?

The life insurance proceeds usually go into the policyholder's estate if no beneficiary is named. They are distributed according to the will or state intestacy laws. This process could lead to delays and potential tax implications.

Is whole life insurance taxable?

Whole life insurance itself is not typically subject to income tax. The proceeds from a whole life insurance policy are not considered taxable income to the beneficiaries.

Is life insurance considered income?

Life insurance proceeds paid out as a death benefit to beneficiaries are generally not considered taxable income in the United States. This means that the money received from a life insurance policy when the insured person passes away is typically not subject to federal income tax. This applies to most life insurance policies, including term life, whole life and universal life insurance.

Are life insurance settlements taxable?

Life insurance settlements are generally tax-free if paid out directly to a beneficiary upon the death of the insured. However, any interest accrued becomes taxable.

Are dividends from life insurance taxable?

Dividends paid from a life insurance policy are typically not taxable as they are considered a return of premiums unless they start accruing interest.

Are life insurance loans taxable?

No, life insurance loans are not taxable as long as the policy remains active. However, if the policy lapses or is surrendered, the outstanding loan amount may become taxable.

Can life insurance be tax deductible?

Life insurance premiums are generally not deductible unless they are paid as part of a business expense, making the cost a potential life insurance business expense.

What is considered a major tax advantage of life insurance?

A major tax advantage of life insurance is the tax-deferred accumulation of cash value, which means no taxes are due on the growth until funds are withdrawn. Additionally, beneficiaries generally receive death benefits tax-free, providing significant financial protection without the added tax burden.

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About Mandy Sleight

Mandy Sleight is a licensed property, casualty, life and health insurance agent with 20 years of experience in the industry. She has worked for major insurance companies like State Farm and Nationwide, and most recently as the Operations Coordinator for a startup employee benefits company.

Sleight holds a business administration and management degree from the University of Baltimore and a master's in business administration from Southern New Hampshire University. She uses her vast knowledge of insurance and personal finance to create easy-to-understand and engaging content to help readers make smarter choices with their budgets and finances.

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sources

Internal Revenue Service. "Estate Tax." Accessed November 20, 2024.
Internal Revenue Service. "Group-term Life Insurance." Accessed November 20, 2024.
Internal Revenue Service. "Life Insurance & Disability Insurance Proceeds." Accessed November 20, 2024.
Tax Foundation. "Facts & Figures 2024: How Does Your State Compare?." Accessed November 20, 2024.

Is Life Insurance Taxable?

Key Takeaways

Do You Pay Taxes on Life Insurance?

Types of Taxes on Life Insurance Payouts

Factors Affecting the Taxable Status of Life Insurance

When Is Life Insurance Not Taxable?

When Is a Life Insurance Payout Taxable?

Is Life Insurance Tax Deductible?

How to Avoid Paying Taxes on Life Insurance

Get the death benefit as a lump sum

Withdraw less than the policy basis

Don’t overpay your premiums

Pay back your cash value loan

Transfer ownership to an irrevocable life insurance trust (ILIT)

Compare Life Insurance Rates

Frequently Asked Questions About Life Insurance and Taxes

Learn More About Life Insurance

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