For the most part, life insurance proceeds are not taxable. That’s good news if you’re the beneficiary of your great-aunt’s million-dollar policy.
But 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. 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. Although rare, the life insurance payout can be taxable in the following situations:
The insurer issues the death benefit in installments
Instead of a lump sum payout, the life insurance beneficiary might receive the death benefit in installments. 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. Although the original death benefit is tax-free, the interest that accumulates is subject to income tax.
The death benefit becomes part of your estate
The federal estate tax exemption limit is $11.58 million, which means if your estate’s total taxable value is greater than this amount, the IRS levies an estate tax. The bottom line is that if you know your estate won’t exceed $11.58 million, you don’t need to worry about this tax. Plus, proceeds left to your spouse are typically exempt from estate tax, even if they exceed the federal limit.
However, if you own your life insurance policy when you die, the IRS includes the payout in your estate, regardless of whether you name a beneficiary. This could push your estate’s total taxable value over the federal exemption limit if you already have a sizable estate. 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, while New York’s kicks in after $5.74 million. Talk to a tax professional to learn how life insurance can affect estate taxes.
One way to keep your life insurance death benefit out of your estate is to transfer ownership to someone else before you die. But be mindful of the three-year rule, which 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:
- The insured: The person whose life the policy covers.
- The policy owner: The person who buys and/or owns the policy.
- 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 policy owner, you’re considered the donor and could be liable for gift tax.
But because of the way gift tax works, you 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 $15,000 a year per recipient — is worth more than $11.58 million.
Even if you don’t end up paying gift tax, you typically need to report all sizable gifts on your income tax return to keep track of your overall total.
Is the cash value in life insurance policies taxable?
Whole life insurance and most other permanent life insurance policies accumulate cash value, which you can withdraw or borrow against as long as the policy is active.
For the most part, this cash is tax-deferred, meaning you only pay taxes on it if you access it. And even then, the IRS only levies a tax 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.
Keep in mind that withdrawing money from the policy’s cash value can reduce 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.
You sell the policy
Selling your life insurance policy — often called a life settlement — 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:
- Income tax is due on any proceeds that exceed the policy basis.
- Capital gains tax is due on any proceeds that exceed 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 a large amount of money, 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: Let’s 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, which in the above example is $5,000. 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.
Keep in mind 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.
Is group term life insurance taxable?
The premiums for an employer-paid supplemental life insurance policy under $50,000 are tax-free to the employee. However, the premiums for policies that exceed $50,000 are 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.
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.