Is Life Insurance Taxable?

Key takeaways:

• Life insurance payouts are usually tax-free.

• If your policy’s payout causes your estate’s worth to exceed $12.06 million, your heirs might be charged estate taxes.

• Your beneficiaries might pay taxes if they choose to receive the payout in installments, or if the policy is owned by a third party.

For the most part, life insurance payouts are not taxable. But if you are a beneficiary, don’t start spending the money in your head just yet.

Some situations can lead to taxation, particularly if you earn interest on the proceeds or the policy owner had a high net worth. Understanding how and when these taxes apply can help you avoid any surprises.

Is a life insurance payout taxable?

One of the perks of a life insurance policy is that the death benefit is typically tax-free. Beneficiaries generally don’t have to report the payout as income, making it a tax-free lump sum that they can use freely.

That being said, there are exceptions. A life insurance payout can be taxable in the following situations:

The insurer issues the death benefit in installments

The death benefit is typically paid out in a lump sum, but the life insurance beneficiary may be able to elect to receive the payout in installments, otherwise known as an annuity. If this happens, the insurer typically holds the principal amount in an interest-bearing account and issues a percentage of the death benefit over a set number of years.

While installments provide a steady income stream, the interest that accumulates on the death benefit is subject to income tax. The original life insurance death benefit typically isn’t, though.

The death benefit becomes part of your estate

In 2022, the federal estate tax exemption limit is $12.06 million for an individual, and $24.12 million for a married couple filing jointly^[0]

If you die while holding a life insurance policy, the IRS will count the payout in the value of your estate — regardless of whether you name a beneficiary. The payout could push your estate’s total taxable value over the limit, and your heirs would have to pay an estate tax on any assets above the threshold within nine months of your death.

If you have a will or trust in place and name your estate as the beneficiary of your policy, the life insurance payout can be used to pay estate taxes. But if you choose one or more individuals as beneficiaries, they won’t be held liable for estate tax — they will receive the life insurance payout tax-free, and estate taxes will be paid from other assets you owned.

In addition to the federal estate tax, some states levy their own estate or inheritance taxes. Exemption limits vary among states. For example, Oregon’s estate tax kicks in after $1 million^[0]

The bottom line? If you know your estate is worth less than $12.06 million, your loved ones won’t be hit with estate taxes. Plus, proceeds left to your spouse are typically exempt from estate tax, even if they exceed the federal limit.

If you are a high net worth individual with a sizable estate, you can keep your life insurance death benefit from being counted as part of your estate by transferring ownership to an irrevocable life insurance trust, or ILIT, and paying premiums out of the trust account. This puts the policy and the disbursement of the payout under the trust’s control, so it’s excluded from the value of your estate.

With ILITs, the rules are complex and must be followed to the letter. To prevent your policy from being brought back into the estate, it’s worth working with an advisor to set up the trust correctly. For example, the three-year rule states a policy is still part of your estate if a transfer of ownership occurs within three years of your death.

The policy involves three different people

The death benefit may be subject to gift tax if different people fill each of the policy’s three roles:

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, you buy a policy for yourself and your child receives the death benefit if you die.

However, if a different person fills each role, the IRS considers the death benefit a gift from the policy owner to the beneficiary. For instance, if you buy a policy to cover your spouse’s life and your child is the beneficiary, the death benefit is technically a gift from you (the owner) to your child (the beneficiary). As the policy owner, you’re considered the donor and could be liable for gift tax.

Because of the way gift tax works, your loved ones probably won’t end up paying it anyway. The tax wouldn't be due until you die, and then only if your estate — including any gifts you’d made of more than $16,000 a year per recipient — is worth more than $12.06 million^[0]

Even if you don’t end up paying gift tax, you typically need to report all sizable gifts using 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 earn cash value over time, which you can withdraw or borrow against when you’ve built up enough and as long as the policy is active.

For the most part, this cash is tax-deferred, meaning you only pay income taxes on it if you withdraw funds from the policy. And even then, the IRS levies a tax only on the amount that exceeds the policy basis — this is the sum of what you’ve already paid in premiums, minus any dividends you receive.

So as long as you withdraw less than the policy basis, the cash value is tax-free money. Any withdrawals over the policy basis are subject to income tax.

Note that withdrawing money from the policy’s cash value reduces the death benefit, leaving your beneficiaries with a lower payout.

If you overpay your premiums, the IRS may classify your life insurance policy as a modified endowment contract, or MEC. This means the IRS taxes cash value withdrawals as income first, even if you take out less than the policy basis. Speak to a tax professional if you think your policy has MEC status.

Situations when the cash value is taxable

Although uncommon, accessing more than the policy basis can trigger a considerable tax bill, so it’s worth knowing how and when this can happen. Here are three situations to look out for:

You surrender the policy

When you surrender a permanent life insurance policy, you’re essentially canceling the coverage, and the insurer pays out the policy’s cash value, minus any surrender fees. The portion of the cash value that exceeds the policy basis is taxable. For example, if you surrender a $10,000 policy and the policy basis is $5,000, the IRS considers the additional $5,000 as income and taxes it accordingly. The taxable amount reflects the investment gains you earned from the policy.

You sell the policy

Selling your life insurance policy — often called a life settlement — to a third party can get you more money than surrendering it. This is because the policy’s sale price is not capped at the cash value amount, but rather based on a variety of factors, such as your life expectancy, the death benefit and the cost of the premiums.

The IRS levies two types of tax on the sale of a life insurance policy, and both are based on profits you made:

1. Income tax is due on the amount of cash value that exceeds the policy basis.

2. Capital gains tax is due on any other profits from the sale, such as money you receive that is more than the policy’s cash value.

If you want to get out of a life insurance policy and buy another one, you may be better off trading it as part of a 1035 exchange — a provision in the U.S. tax code that allows you to exchange similar properties without paying 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 basis. This means you can borrow against your life insurance policy, tax-free, as long as you repay it. However, if you fail to repay the loan, the tax implications can be severe.

Here’s an example: Say your policy has $10,000 in cash value and the policy basis is $5,000, meaning you’ve paid $5,000 in premiums. If you take out a $9,000 loan, you don’t have to pay taxes on the additional $4,000 as long as the policy is active. But as the loan accrues interest, the amount you owe can become greater than the cash value. At this point, you must repay the loan or the insurer can cancel the policy.

If the insurer cancels the policy, it typically uses cash value to repay the loan, and you pay tax on the amount that exceeds the policy basis. This is where you can run into trouble. Not only were you struggling to repay the loan, but you’re now also hit with a big tax bill.

Note that if you die before paying off the loan, any amount you still owe is taken from the death benefit, which means your beneficiaries receive less money.

» MORE: The tax consequences of whole life insurance

Are life insurance dividends taxable?

You don’t typically pay taxes on dividends because the IRS considers them refunds of your premiums. However, if the insurer places the dividends in an interest-bearing account, the gains you receive are subject to income tax. Similarly, if you receive more in dividends than what you’ve already paid in premiums, the difference is typically taxable.

» MORE: The cost of whole life insurance, and why it’s so high

Is group term life insurance taxable?

There are nuances with group life insurance policies, which some companies offer as an employee benefit. If you have a policy worth less than $50,000, the premiums aren’t taxable. But if your coverage exceeds $50,000 and your employer subsidizes all or part of the cost, the premiums will be subject to income tax. This is because the IRS considers the life insurance premiums your boss pays to be part of your compensation.

Only the portion of the premium that pays for the coverage that exceeds $50,000 is taxed. Some employers increase the employee’s income to account for the tax.

If you pay the premiums yourself for life insurance you purchased through work, no income tax is due.

» MORE: Average life insurance rates

A summary of when life insurance is taxable