Typically, you don’t need to pay taxes on life insurance pay-outs, but there are some exceptions.
Updated:
Apr 13, 2024
Written by
Scott Karstens
Scott Karstens
Edited by
Sabrina Lopez
Sabrina Lopez
Life insurance generally ensures your beneficiaries receive a tax-free death benefit, but in some cases, proceeds from a policy can be taxable. The factors that affect the taxable status of life insurance include the death benefit, premiums, cash value and access to it.
You can avoid unexpected tax consequences for your family by consulting a financial advisor when shopping for the best life insurance. In this article, we at the MarketWatch Guides team will explain situations in which life insurance policy proceeds can be subject to taxes.
Is Life Insurance Taxable?
Named beneficiaries do not generally have to pay estate or income taxes on the proceeds of a life insurance policy. However, there are some cases in which a life insurance payout can be taxable. For instance, if it’s paid out in installments, the interest accrued will be taxable. If you take out a loan against your policy’s cash value and the policy lapses before you repay it, you will pay taxes on the outstanding loan amount.
Other instances that can affect life insurance’s taxable status include whether your employer pays your premiums or if the death benefit is included in your estate’s value and the value exceeds a certain threshold.
Tax Treatment of Life Insurance Proceeds
Life insurance proceeds and death benefit are synonymous: It’s the amount that the insurance company will pay your beneficiaries upon death.
Understanding the tax treatment of the types of life insurance proceeds as part of your estate is an important factor to consider when planning for your future. According to the IRS, life insurance proceeds are generally not taxable income, so your loved ones won’t have to pay taxes on any money paid out by the insurer upon death.
However, some exceptions do exist that could affect the way your beneficiaries receive their life insurance payout upon your passing.
Understanding these rules can be the difference maker between your loved ones receiving the death benefit with, or without an added tax surprise.
Life Insurance Policy Payment Options
There are three main ways for beneficiaries to receive payments from a life insurance policy:
- Lump sum
- Accumulate interest
- Installments
The form of the final life insurance payout will depend on the needs and financial situation of the beneficiary.
Some policies may include additional riders or benefits that could affect the tax implications of each option, so read your policy carefully before making any decisions about payout options.
Lump Sum Payout
A lump sum payout is the simplest option for receiving life insurance proceeds, giving you the flexibility to use the life insurance payout however you please.
For some though, receiving such a large amount at once can be overwhelming, so we recommend consulting with a financial or a tax professional to discuss your options.
Interest-Bearing Account
Leaving the payout in an interest-bearing account allows you to earn interest from the insurance company and often provides a checkbook or a debit card for you to use the proceeds from the coverage amount. Leaving the payout with the insurance company in an interest-bearing account eliminates FDIC insurance limits. However, keep in mind that the interest earned will be taxable and might not be the highest you can get.
Lifetime or Installment Payments
Receiving lifetime or installment payments allows you to receive guaranteed payments for the rest of your life based on your age and policy proceeds. Similar to annuity payments, you can often choose installment payments that may only last for a few years or for your lifetime.
Either way, these options might make sense if you’re worried about blowing through a lump sum payout. Plus, you could get more than the policy’s death benefit amount if you live longer than the insurance company expected.
Choosing the option that works best for you may require working with a licensed insurance agent or a qualified tax professional so you can rest easy knowing you’ve made an informed decision about your life insurance death benefit payout options.
Tax Considerations for Cash Value Growth
Cash value growth within permanent life insurance policies is generally considered to be tax-deferred. Permanent life insurance policies include whole life insurance, universal life insurance, indexed universal life insurance and variable universal life insurance.
This tax-deferred growth means that any gains from the policy, including interest and dividends that accrue over time, are not subject to taxation until they are withdrawn. This feature allows policyholders to accumulate savings on a tax-deferred basis, which can potentially provide increased financial security and flexibility. The tax deferral can be especially attractive for those who fall into higher tax brackets and may otherwise face significant taxation on investment gains.
Making a Withdrawal
When you withdraw from your policy’s cash value, you do not have to pay taxes up to the “cost basis” or the sum of premiums paid. Based on the FIFO (first in, first out) method, you will withdraw your principal first and interest last. However, if your withdrawals exceed the cost basis, they will be subject to income tax.
If your policy is a Modified Endowment Contract (MEC), the cash value access is subject to different taxation. The LIFO (last in, first out) method will apply in this case, meaning you will withdraw the interest first and pay income taxes. You will also pay a 10% penalty if you are under 50 and a half years old. It’s important to consult a professional to make informed decisions about policy withdrawals.
Policy Loans and Tax Implications
Policy loans allow you to access the cash value in the policy without having to surrender the policy. When you access your life insurance cash value through a policy loan, you receive the money tax-free. It is common to take a policy loan after you have withdrawn money from your policy up to what you originally contributed to avoid taxation on the cash value gain in your life insurance policy.
It is possible to over-loan your policy — and if you do take too many loans from your policy’s cash value, the insurance company may force you to surrender your policy to cover the outstanding loans. If you were forced to surrender your policy, the gains inside your policy would be taxed as income tax.
Estate Taxes and Life Insurance
Life insurance is a common tool for estate planning, as it allows you to transfer assets quickly and easily upon death. It is important to understand how your life insurance coverage can be used to help pay your estate taxes, and how life insurance can increase the size of your estate. Following are some key considerations when evaluating the role of life insurance in estate planning and potential estate tax implications.
Using Life Insurance To Pay Estate Taxes
In 2023, if your estate’s value exceeds $12.92 million (or $25.84 million if you’re married), it will be subject to federal estate taxes, ranging from 18% to 40%. Although the death benefit of a life insurance policy is tax-free, it can increase the value of your estate if you own the policy. You can set up an Irrevocable Life Insurance Trust (ILIT) and name it the owner and beneficiary of your policy. If structured properly, the trust can help in paying estate taxes without increasing your estate’s value.
Life Insurance Increasing Your Estate
You can increase your estate’s value when you own life insurance individually. For instance, if you own a life insurance policy individually with your spouse as the beneficiary, the value of your estate will increase by the death benefit amount when you pass away. This could cause a taxable event if your estate is near the tax exemption limit.
Using Life Insurance To Pay Inheritance Tax
There are six U.S. states where you must pay inheritance taxes based on rates as high as 20%. The valuation thresholds in these states are lower than the federal exemptions. This state-level tax is in addition to any federal estate tax.
Other Tax Considerations and Planning Opportunities
Here are a few other considerations when buying life insurance.
Paying for Life Insurance
- A common strategy for life insurance ownership is to have a grandparent pay for the life insurance premiums for a grandchild. While this may not be an issue for many, consider how this arrangement can trigger gift tax or generation-skipping tax for at least the premium payment.
- A business paying for life insurance is another issue to consider. This is very common for a business owner to have their business pay for their life insurance policy. While this may be convenient, this payment should be a taxable event to the owner or employee who owns the life insurance policy. If it is not treated this way, it will cause the death benefit to be taxable.
- Businesses often take advantage of tax deductions. If a business deducts a life insurance premium, this will likely cause a taxable death benefit to the beneficiary if a direct deduction for life insurance occurs rather than deducting the premium through payroll per the earlier example. Remember, life insurance premiums are not tax deductible.
Ownership, Payor and Beneficiary Issues
There are four relationships (parties) to pay attention to in a life insurance policy:
- The policy owner
- The insured person
- The payor
- The life insurance beneficiary(ies).
Paying attention to the relationship of these parties is important. Here is one common example for a business owner causing a taxable death benefit:
Example:
- Drew buys a life insurance policy on himself.
- Drew is also a business owner and elects to make his business the owner of his policy.
- He then decides to have the business pay the premiums for the policy.
- The policy beneficiary is his wife who is not an employee or principal of the business.
The business owner buys a life insurance policy on himself and the business is the owner of the life insurance policy. They then choose to have their business pay the premium. So far, this is normal. But, the owner chooses to name their spouse or family as the beneficiary. This would most likely cause a taxable benefit if not accounted for properly.
Address additional tax considerations, such as gift tax implications and beneficiary designations.
Discuss planning opportunities, including irrevocable life insurance trusts and tax-efficient policy structuring.
Our Conclusion: Is Life Insurance Taxable?
Life insurance can be a valuable tool for business, personal and estate planning as it enables quick and easy transfer of assets when a person passes away. Plus, it offers tax-favorable cash value accumulation as well as access to the cash value in the policy.
When you are looking to use life insurance as a planning strategy, don’t leave it solely to the IRS to dictate your taxation. There is significant value in working with professionals to help guide the proper plan for you as well as a qualified tax advisor to help make sense of any tax implications for your situation.
Regardless of the tax implication, life insurance proceeds can help your beneficiaries during a difficult time. Term life insurance can be an affordable way to get started providing this protection for your family.
Frequently Asked Questions About Life Insurance and Taxes
Typically no tax is due on the death benefit received as a beneficiary. There are some circumstances that could create federal estate tax, income tax or inheritance tax. Always consult a tax professional to be sure.
Having the proper ownership, payor and beneficiary structure is a good start on avoiding tax on life insurance proceeds. Working with a professional insurance agent and a qualified tax advisor can provide significant value as well on the tax implications of life insurance proceeds.
Yes, the life insurance company will send the beneficiary a 1099 for their tax return when they send out life insurance death benefit payment.
There is not a specific life insurance tax rate. When accessing a policy’s cash value, you can expect to pay income tax at your income tax rate on the interest if you withdraw money beyond your basis. Utilizing policy loans may also help you avoid paying tax on access to your cash value.
Yes, life insurance proceeds need to be included on your income taxes. You will receive a 1099 for life insurance proceeds and that must be included in your tax return. It does not necessarily mean you will pay tax on the money received.