Is Life Insurance Taxable

Most life insurance payouts are not taxable. But if you are a beneficiary, don’t start spending the money in your thoughts right away.

Some instances may result in taxation, particularly if you receive interest on the funds if the policy holder has a high net worth. Understanding how and when these taxes apply will help you prevent surprises.

Is a life insurance payout taxable?

One advantage of a life insurance policy is that the death benefit is usually tax-free. Beneficiaries are often not required to disclose the award as income, resulting in a tax-free lump sum that they can spend as they see fit.

However, there are several exceptions. A life insurance payout may be taxed in the following situations:

The insurer issues the death benefit in installments

The death benefit is normally paid out in one lump sum, however the life insurance recipient may be able to choose to receive the payout in installments, often known as annuities. If this occurs, the insurer normally retains the original amount in an interest-bearing account and pays out a percentage of the death benefit over a certain number of years.

While monthly payments provide a consistent source of income, the interest earned on the death benefit is taxed. However, the initial life insurance death benefit is rarely paid.

The death benefit becomes part of your estate

In 2024, the federal estate tax exemption limit for individuals is $13.61 million. This means that if you die in 2024 and your entire taxable value exceeds this threshold, the IRS will charge an estate tax.

If you die while holding a life insurance policy, the IRS will include the payout in the value of your estate, regardless of whether you have designated a beneficiary. The payout could raise your estate’s total taxable worth above the limit, requiring your heirs to pay estate taxes on any assets above the threshold within nine months after your death.

If you have a will or trust in place and identify your estate as the beneficiary of your life insurance policy, the proceeds can be used to pay estate taxes. However, if you designate one or more individuals as beneficiaries, they will not be subject to estate tax – they will get the life insurance payout tax-free, and estate taxes will be paid from other assets you hold.

In addition to the federal estate tax, some states have their own estate or inheritance taxes. Exemption limitations vary by state. For example, New York’s estate tax applies after $6.94 million. Consult a tax professional to learn how life insurance can impact estate taxes.

What’s the bottom line? If you know your estate is worth less than $13.61 million, your loved ones will not have to pay estate taxes. Furthermore, assets left to your spouse are generally excluded from estate tax, even if they exceed the federal limit.

If you are a wealthy individual with a large estate, you can avoid having your life insurance death benefit counted as part of your estate by transferring ownership to an irrevocable life insurance trust, or ILIT, and paying premiums from the trust account. This transfers control of the policy and payout disbursement to the trust, excluding it from the worth of your inheritance.

ILITs have intricate rules that must be strictly adhered to. To avoid having your policy dragged back into the estate, consult with an advisor to properly set up the trust. For example, the three-year rule provides that if you transfer ownership of a policy within three years of your death, it remains part of your estate.

The policy involves three different people

If the policy’s three responsibilities are filled by separate people, the death benefit may be liable to gift tax.

1. The insured: The person whose life the policy covers.
2. The policy owner: The person who buys and/or owns the policy.
3. The beneficiary: The person who receives the death benefit if the insured party dies.

In most cases, only two people are involved. For example, suppose you purchase insurance for yourself, and your child receives the death benefit if you die.

If a different person fills each duty, the IRS views the death benefit as a gift from the policy owner to the beneficiary. For example, if you purchase a policy to cover your spouse’s life and name your child as the beneficiary, the death benefit is considered a gift from you (the owner) to your child (the beneficiary). As the policy owner, you are deemed the giver and may be subject to gift tax.

Because of the way the gift tax works, your loved ones are unlikely to pay it regardless. The tax would not become due until you died, and only if your estate — including any donations of more than $18,000 per recipient — exceeded $13.61 million.

Even if you don’t have to pay gift tax, you must normally disclose all significant contributions on a gift tax return (IRS Form 709).

Is the cash value in life insurance policies taxable?

Whole life insurance and most other permanent life insurance policies accumulate cash value over time, which you can take or borrow against once you’ve accumulated enough and the policy is active.

For the most part, this cash is tax-deferred, which means you only pay income taxes on it when you withdraw it from the insurance. Even then, the IRS only charges a tax on the amount that exceeds the policy basis — which is the sum of premiums paid minus dividends received.

So long as you withdraw less than the insurance limit, the cash value is tax-free. Income tax applies to any withdrawals made in excess of the policy’s basis.

It should be noted that removing money from the policy’s cash value affects the death benefit, resulting in a reduced payout for your beneficiaries.

If you overpay your premiums, the IRS may consider your life insurance policy a modified endowment contract, or MEC. This means that the IRS taxes cash value withdrawals as income first, even if you withdraw less than the policy base. If you believe your policy meets the criteria for MEC status, consult with a tax professional.

Situations when the cash value is taxable

Although uncommon, accessing more than the policy basis might result in a significant tax liability, so it’s important to understand how and when this can occur. Here are three scenarios to watch out for:

You surrender the policy

When you surrender a permanent life insurance policy, you effectively cancel the coverage, and the insurer pays out the policy’s cash value, minus any surrender fees. The amount of cash value that exceeds the insurance basis is taxed. For example, if you surrender a $10,000 policy with a policy basis of $5,000, the IRS counts the additional $5,000 as income and taxes it accordingly. The taxable amount reflects the investment profits from the policy.

You sold the policy

Selling your life insurance policy to a third party, often known as a life settlement, can result in a higher payout than relinquishing it. This is because the policy’s sale price is not limited to the cash value amount, but is determined by a number of criteria, including your life expectancy, the death benefit, and the cost of premiums.

The IRS imposes two types of taxes on the sale of a life insurance policy, both of which are based on the profits made:

1. Income tax is imposed on any cash value that exceeds the policy base.
2. Capital gains tax is required on any additional earnings from the sale, such as money received in excess of the policy’s cash value.

If you wish to sell a life insurance policy and buy another, you could be better off doing so through a 1035 exchange, which allows you to trade equivalent properties without incurring capital gains tax.

You take out a loan against the cash value

Cash value loans are tax-deferred, even if you borrow more than the policy limits. This means you can borrow against your life insurance coverage tax-free as long as you pay it back. However, if you fail to repay the loan, the tax consequences might be serious.

Here’s an example. Assume your policy has $10,000 in cash value and a policy basis of $5,000, which means you’ve paid $5,000 in premiums. If you take out a $9,000 loan, you will not have to pay taxes on the remaining $4,000 as long as the policy is current. However, if the loan accrues interest, the amount you owe may exceed the cash value. At this time, you must repay the loan or the insurer may cancel your coverage.

If the insurer cancels the policy, it usually uses cash value to repay the loan, and you are taxed on the amount that exceeds the policy limit. This is where you could get into trouble. Not only were you straining to repay the loan, but you’re now facing a large tax obligation.

It is important to note that if you die before paying off the loan, any outstanding balance is deducted from the death benefit, resulting in less money for your beneficiaries.

Are life insurance dividends taxable?

Dividends are normally tax-free since the IRS considers them to be refunds of premium payments. However, if the insurer places the dividends in an interest-bearing account, the gains are taxed as income. Similarly, if you receive more dividends than you have paid in premiums, the difference is usually taxed.

Is group term life insurance taxable?

There are nuances to group life insurance coverage, which some employers provide as an employee benefit. Premiums for policies valued less than $50,000 are not taxed. However, if your coverage exceeds $50,000 and your employer subsidizes all or part of the cost, the premiums will be taxable. This is because the IRS considers the life insurance premiums paid by your employer to be part of your remuneration.

Only the percentage of the premium that goes toward coverage that exceeds $50,000 is taxed. Some employers boost the employee’s income to cover the tax.

If you pay the premiums for life insurance obtained through your employer, no income tax is owed.

A summary of when life insurance is taxable