If you’ve recently become the beneficiary of a life insurance policy, you may wonder if the death benefit you’ll receive is tax-free. The good news is most life insurance proceeds are not considered taxable income by the Internal Revenue Service (IRS).
However, there are a few situations where a life insurance death benefit could become subject to income tax or other types of taxes like federal estate tax. Let’s take a closer look at when you might have to pay taxes on life insurance and how to ensure your loved ones get the full benefit of a life insurance payout.
Learn more: What is life insurance?
The short answer is no. Most life insurance proceeds are not taxable. The advantage of life insurance is that the policyholder financially provides for loved ones in the aftermath of a death or permanent disability.
A payout from a life insurance company can cover big expenses like funeral costs, paying down debt, and providing financial peace of mind without adding to the beneficiary’s gross income.
While most term life insurance payouts are exempt from tax liability, there are other types of life insurance policies whose death benefit could become subject to state or federal income tax. Specifically, these include life insurance that has cash value, group life insurance, life insurance distributed in installments or directly to an estate.
The following situations can have different tax implications and should be considered carefully as part of an estate planning process.
When a life insurance policy gets distributed in installments instead of a lump sum, it’s called a life insurance annuity. While the death benefit itself is tax-free, any interest that accrues should be reported on your tax return as income.
The cliche that three is a crowd also applies to life insurance. This particular life insurance tax, sometimes referred to as a Goodman Triangle, happens when three people are involved in a life insurance policy.
If the beneficiary, policyholder, and insured are all different people, the IRS views the insurance policy as a gift. As such, if the total benefit amount exceeds the annual gift exclusion limit, it becomes taxable.
If you sell a life insurance policy because you need the cash more than the insurance coverage, be prepared to pay taxes, specifically income and capital gains tax.
Any money you recover in the sale that is equal to what you paid in life insurance premiums won’t be taxed, but any profits you make in excess of the amount of premiums is taxed as income.
If your estate is the beneficiary of your life insurance policy, it could trigger some estate taxes. This happens when the death benefit pushes the estate’s value over a certain threshold. While the estate value threshold is quite high for federal taxes (upwards of $13.9 million for 2024 taxes), be warned that the taxable estate threshold is different for every state.
For instance in California, there is no estate or inheritance tax, but New York levies an estate tax on high-value estates above the $6.5 million threshold.
If business owners choose to extend group life insurance benefits to employees over $50,000, that payout is regarded as taxable income by the IRS. Even if employees partially pay for this life insurance policy, it can be taxable as long as the employer pays any part of the premium.
Permanent life insurance policies such as whole or universal life insurance have cash value, sometimes referred to as surrender value, that follows different tax rules.
Generally, policyholders can borrow against a permanent life insurance policy’s cash value as long as those withdrawals don’t exceed the premium payments. However, if the policy loans you’re taking out inch over the line of what’s paid in premiums, that additional money is considered taxable income.
For whole life insurance policies, dividends aren’t taxable but any interest earned on those same dividends should be reported as income to the IRS.
Learn more: What is universal life insurance?
To ensure your loved ones will receive the full benefit of your life insurance policy, it pays to do the following and consult a tax professional.
It may seem like dolling out life insurance money bit by bit might help a beneficiary stay on budget, but the tax penalties likely offset any of those benefits. Choose lump sum payouts over installments or annuities to avoid tax liability.
2. Review policies and beneficiaries regularly
An annual update and review of your life insurance is a great way to check that you haven’t borrowed more than the policy’s cash value or paid too much in premiums, and that the beneficiaries of your policy are up to date.
Consulting with a tax professional to conduct estate planning is preferred, but the IRS also has an online tool that can help determine if your life insurance will provide tax-free benefits to your loved ones.
One way to avoid estate tax is to set up an irrevocable life insurance trust (ILIT) which ensures that upon death, proceeds of a life insurance policy will be transferred to a trust and be distributed to certain beneficiaries.
Looking for a few ways to spend a tax-free windfall responsibly? Financial advisers recommend putting the proceeds toward digging out of high-interest debt first, then focusing on building an emergency fund.
If you’ve already got your financial ducks in a row, you can put a large life insurance payout to work in a high-yield savings account.
Learn more: The total guide to life insurance
Generally, as a beneficiary of a life insurance policy you are not required to report the proceeds as taxable income to the IRS.
However, there are some exceptions, so consult the IRS website if you plan to take the insurance payout in installments, you’ve sold an insurance policy at a profit, or the proceeds are from a permanent life insurance policy that has cash value.
Life insurance premiums on personal policies are not typically tax-deductible. However, if the policy is a gift to a charitable organization or you’re a business owner and you pay premiums for an employee, those premiums may be tax-deductible. Consulting with a tax professional is the best way to decide which tax rules apply to your situation.
Life insurance proceeds cannot be used to pay off any estate debts unless the beneficiary of the life insurance policy is the estate itself. This sometimes happens if no beneficiaries are identified or if the policy beneficiaries are no longer alive.
In this case, the estate would go into probate and creditors could require the life insurance payout to cover any remaining debts from the deceased.
