If you have recently become the beneficiary of a life insurance policy, you may wonder whether the death benefit you receive is tax-free. The good news is that most life insurance proceeds are not considered taxable income by the Internal Revenue Service (IRS).
However, there are some situations in which a death benefit from a life insurance policy could be subject to income taxes or other types of taxes, such as federal estate taxes. Let’s take a closer look at when you might have to pay taxes on life insurance and how you can ensure your loved ones get the full benefit of a life insurance payout.
More information: What is life insurance?
The short answer is no. Most life insurance proceeds are not taxable. The benefit of life insurance is that the policyholder provides financially for loved ones in the aftermath of death or permanent disability.
A payout from a life insurance company can cover major expenses such as funeral costs, paying off debts and providing financial peace of mind without adding to the beneficiary’s gross income.
Although most term life insurance payouts are exempt from tax liability, there are other types of life insurance policies whose death benefits could be subject to state or federal income taxes. This mainly concerns life insurance policies with a cash value, group life insurance policies and life insurance policies that are distributed in installments or directly into an estate.
The following situations may have different tax implications and should be carefully considered as part of an estate planning process.
When a life insurance policy is paid out in installments instead of in a lump sum, it is called an annuity policy. Although the death benefit itself is tax-free, any accrued interest must be reported as income on your tax return.
The cliché that three is a lot also applies to life insurance. This specific life insurance strain, also called a Goodman Triangle, occurs when three people are involved in a life insurance policy.
If the beneficiary, policyholder, and insured are all different people, the IRS considers the insurance policy a gift. Therefore, if the total distribution amount exceeds the annual gift exclusion limit, it becomes taxable.
If you sell a life insurance policy because you need the money more than the insurance coverage, be prepared to pay taxes, especially income and capital gains taxes.
Any money you get back from the sale that is equal to what you paid in life insurance premiums will not be taxed, but any profits you make in excess of the amount of premiums will be taxed as income.
If your estate is the beneficiary of your life insurance policy, this may give rise to estate taxes. This happens when the death benefit pushes the value of the estate over a certain threshold. Although the property value threshold is quite high for federal taxes (over $13.9 million pre-tax in 2024), keep in mind that the taxable property threshold is different for each state.
For example, in California there is no estate or inheritance tax, but New York imposes 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 considered taxable income by the IRS. Even if employees partially pay for this life insurance, it may be taxable as long as the employer pays part of the premium.
Permanent life insurance policies, such as whole or universal life insurance, have a cash value, also called a surrender value, which follows different tax rules.
Generally, policyholders can borrow against the cash value of a permanent life insurance policy, as long as those withdrawals do not exceed premium payments. However, if the policy loans you take out are greater than what was paid in premiums, that extra money is considered taxable income.
For whole life insurance policies, dividends are not taxable, but any interest earned on those same dividends must be reported as income to the IRS.
More information: What is universal life insurance?
To ensure that your loved ones receive the full benefit of your life insurance policy, it is worth doing the following and consulting a tax advisor.
It may seem like handing out life insurance money a little at a time can help a beneficiary stay within budget, but the tax penalties likely offset all of these benefits. Choose lump sum payouts instead of installments or annuities to avoid tax liability.
2. Review policies and beneficiaries regularly
An annual update and review of your life insurance policy is a good way to check that you have not borrowed more than the cash value of the policy, or paid too many premiums, and that the beneficiaries of your policy are aware.
It is preferable to consult a tax professional to conduct estate planning, but the IRS also has an online tool that can help you determine whether your life insurance policy provides tax-free benefits to your loved ones.
One way to avoid estate taxes is to set up an irrevocable life insurance trust (ILIT), which ensures that upon death, the proceeds of a life insurance policy are transferred to a trust and distributed to specified beneficiaries.
Looking for ways to spend a tax-free windfall responsibly? Financial advisors recommend spending the proceeds first on reducing high-interest debt and then focusing on building an emergency fund.
If you already have your financial affairs in order, you can put a large life insurance payout into a high-yield savings account.
More information: The complete guide to life insurance
Generally, as the 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 check the IRS website if you plan to pay out the insurance in installments, if you sold an insurance policy at a profit, or if the proceeds are from a permanent life insurance policy with cash value.
Life insurance premiums on personal policies are generally not tax deductible. However, if the policy is a gift to a charitable organization or you are a business owner paying premiums for an employee, these premiums may be tax deductible. Consulting with a tax professional is the best way to determine which tax rules apply to your situation.
Life insurance proceeds cannot be used to pay off estate debts unless the beneficiary of the life insurance policy is the estate itself. This sometimes happens when no beneficiaries are identified or when the policy beneficiaries are no longer alive.
In this case, the estate would go into probate and creditors could demand the payout of the life insurance policy to cover any remaining debts of the deceased.
