Life Insurance Tax Guide

When it comes to life insurance, taxes are a common worry. You may be wondering, “is life insurance taxable?” The answer to this question depends on a few different factors.

Whether you will have to pay tax depends on the type of life insurance policy you have, who is involved in the policy and whether the insurance payout is considered part of the estate. 

Most of the time, life insurance is not taxable. This is because the proceeds or “death benefits” are not considered income. However, there are some exceptions to this rule where life insurance may be taxable. 

Types of Tax That Can Make Life Insurance Taxable

One of the first things to understand is how different types of tax work alongside your life insurance policy. There are several types of U.S. tax to take into account that may affect life insurance payouts.

In some cases, you may not be liable for income tax on life insurance payouts, but you may be for estate tax. If you are in one of the states where inheritance tax applies, you may need to pay tax on any assets you receive from the deceased person. 

The following types of tax will need to be considered when you take out a life insurance policy:

• Income Tax – Income tax is the most well-known type of tax that applies to most people. It’s a federal or state tax on your income that is taken by the Internal Revenue Service (IRS). The IRS takes the amount you have earned throughout the year and deducts income tax based on your net income minus expenses. How much they take will depend on your individual tax bracket. 
• Inheritance Tax – This is a state tax that applies to an individual who receives an inheritance. Unlike the estate tax, the individual is taxed rather than the estate.  Typically, spouses are exempt, but it can apply to children or domestic partners in certain states. Only six states have inheritance tax, including Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. 
• Estate Tax – Estate tax is something that the federal government and some states will take from the deceased person’s estate. The estate is the total combined assets, including property and investment, minus anything that is owed, like loans. They then tax that final number and take the tax from the estate itself. Only estates over $11.58 million (as of 2020) have to pay this. 
• Generation-Skipping Tax – This tax applies when an inheritance skips over the next immediate descendant. For example, when someone passes on assets to a grandchild rather than their child.

When Is Life Insurance Not Taxable?

In most cases, life insurance will not be taxable if it is paid directly to a beneficiary. There are several other examples in which this is the case. 

When Your Beneficiary Receives a Cash Value Gain

If your life insurance policy is a cash value type, this means the full cash value goes back to the insurance company when the person dies. In some cases, the insurance company will pay out some cash value to beneficiaries, but this is rare. There is no income tax to pay on this type of insurance policy.

When Your Beneficiary Receives a Lump-Sum

If your spouse or other designated beneficiary receives a lump-sum payment, no income tax is due. This lump-sum payout also called a death benefit, may be considered part of your estate.

When You Make a Partial Withdrawal from the Cash Value of Your Permanent Insurance

You can make a partial withdrawal from the cash value portion of your insurance policy while you are still alive and this amount is not taxable. However, if you do not pay it back before your death, this will be subtracted from your death benefit before beneficiaries receive anything. 

When You Receive Annual Dividends

In some cases, insurance companies are structured in a way where the policyholder owns the company “mutually”. This means that the policyholder will receive cash dividends based on the profits of the insurance company. These dividends will not be taxed as long as they are added to your policy’s cash value and do not exceed what you have paid out in premiums that year.  

When You Surrender Your Life Insurance Policy

If you switch to another life insurance policy, this is also called “surrendering” your policy. In this case, you may have accumulated a small amount of cash value in your account. This will be given to you as a lump-sum from the insurance company and this amount is not taxed. That is unless the sum is larger than what you have paid in.

When You Accelerate Your Death Benefit

In certain circumstances such as deteriorating health or terminal illness, you can “accelerate” your death benefit. This means you will be considered your beneficiary, which allows you to get your death benefit early. This is only recommended if your loved ones have another way they will be taken care of. The amount you receive is not usually taxed but it must come within two years of your death. 

When Is Life Insurance Taxable?

While life insurance is not taxable most of the time, there are certain instances where tax is due.

When Your Estate Exceeds the Estate Tax Threshold

Usually, life insurance is paid directly to beneficiaries. However, life insurance payouts can sometimes form part of the estate of the deceased person instead. 

This happens when there is no named beneficiary. Still, it can also apply if your policy payout is set to skip a generation (the beneficiary is a grandchild rather than a child). In this case, the payout will be considered part of the estate. 

The estate tax threshold is $11.58 million so anything above that threshold is liable for tax. This means you will have to check whether this insurance payout pushes the value of the estate above the estate tax threshold. 

When More Than Two People Are Involved

Most insurance policies will involve two people — the owner of the policy and the beneficiary. In some cases, there can be an owner of a policy, the insured person and the beneficiary. For example, a parent can buy life insurance for their child with their spouse as the beneficiary. When three people are involved in this way, the death benefit will be taxable for the spouse. 

When You Sell Your Life Insurance Policy

If you decide to sell your life insurance, a broker will take a cut from the amount you receive. This means you will get back less than you are covered for. However, if this amount totals more than the premiums you have paid, you will pay income tax on the amount. 

When You Profit from Surrendering Your Cash Value Policy

If you buy another life insurance policy, surrendering your previous one, you may owe tax. When surrendering your initial policy, you could receive a payout. If this is more than the premiums you have paid over the years, you will need to report this as extra income.

The Bottom Line

When it comes to life insurance, it can get complicated. Is life insurance taxed? In most cases, you will not have to worry about tax. However, there are exceptions to this rule that depend on your circumstances. That’s why it’s so important to keep all of the tax rules in mind when buying life insurance and naming beneficiaries. 

While most life insurance payouts are exempt from tax, you will need to take estate tax into account. This is particularly so if you decide to skip a generation when naming a beneficiary. In this case, the insurance payout forms part of the estate. This means you will need to keep an eye on the estate’s value to see whether it exceeds the threshold for estate tax. 

When dealing with a large estate, you can name the beneficiary of the payout as an irrevocable trust to avoid tax. This means the insurance payout will not be considered part of the estate, which can keep you under the threshold. 

Life Insurance & Taxes FAQs

Will my beneficiaries have to pay taxes from the life insurance proceeds?

Beneficiaries do not usually have to pay tax on life insurance payouts, also called death benefits. If the amount is considered part of the estate, then tax is only due if it exceeds the threshold of $11.58 million. 

Are life insurance proceeds part of my inheritance?

Life insurance payouts are not considered part of your inheritance. Inheritance tax only applies in certain circumstances and states. Spouses are usually exempt, but some children and other beneficiaries may be taxed. 

How can I avoid paying taxes from a life insurance payout?

If your insurance proceeds become part of your estate, it could mean your beneficiaries are liable for estate tax. This happens when the payout pushes the value of your estate above the threshold of $11.58 million. 

To avoid estate tax, you could name the beneficiary as an irrevocable trust instead. This ensures the insurance payout does not become part of the estate, which could push it above the threshold. 

Do I have to pay income taxes from a life insurance payout?

You will not usually have to pay income tax on life insurance if you are a named beneficiary. This is because the IRS does not consider death benefits to be income. However, any interest earned on this amount is taxable. 

The only time you will need to worry about tax is if the payout is considered part of the estate. This could mean that estate tax is due, but it depends on the estate’s value in question.