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Are Life Insurance Proceeds Taxable?

Are Life Insurance Proceeds Taxable? Life insurance proceeds are typically not taxable as income, but can be taxed as part of your estate if the amount being passed to your heirs exceeds federal and state exemptions. You may face income and capital gains taxes if you decide to get rid of your policy through a life insurance settlement or by surrendering it to your insurer.

Are Life Insurance Proceeds Taxable?

Life insurance proceeds are not taxable with respect to income tax, so long as the proceeds are paid out entirely as a lump sum, one time, payment. However, if your beneficiary receives the life insurance payment as a series of installments, the insurer will typically pay interest on the outstanding death benefit. Parents will often request to have their life insurance death benefit paid in installments if their beneficiary is a young child or someone dependent on their income. In these cases, your beneficiary would have to pay income tax on the interest.

Estate taxes are an entirely different matter. When you pass away, the executor of your estate will have to file IRS Form 712 as part of your estate tax return. Form 712 states the value of your life insurance policies based upon when you died. If your spouse is your beneficiary, the life insurance payout is not taxed and will be passed on to them fully, along with the rest of your estate that was left to them. Spouses typically have an unlimited exemption with regards to estate taxes.

If your beneficiary is anyone besides your spouse, such as a child or parent, your life insurance payout will typically be added to the value of your estate. This is fine if the total value of your estate is less than the federal and state exemptions. But if your total estate has a greater value than is exempted, any amount over the exemption will be subject to estate and inheritance taxes.

  • Federal Estate Taxes – The value of your estate that exceeds $11.58 million per individual will be subject to a 40% estate tax rate.
  • State Estate & Inheritance Taxes – There are 18 states, plus D.C., with an inheritance or estate tax. The estate tax exemption amount varies by state, but typically ranges from $1 million to $2 million. Tax rates can be as high as 20% depending upon where you live.

As a note, your life insurance policy would only be considered as a part of your estate for tax purposes. It would not be included in your estate for other purposes, such as paying creditors, unless you named the estate as beneficiary or all your beneficiaries passed away.

Avoid Estate Taxes with an Irrevocable Life Insurance Trust (ILIT)

One way to avoid life insurance payouts being taxed as part of your estate is to set up an irrevocable life insurance trust. You transfer ownership of the policy to the ILIT and cannot be the trustee. However, you can determine who you want as the trust beneficiary.

While an ILIT is an effective way to make sure that your life insurance death benefit is not taxable as part of your estate, there are a couple situations in which you may face a tax event:

  • When setting up the trust, if the life insurance policy’s cash value is greater than the gift tax exemption, you may need to pay a gift tax when transferring ownership. The gift tax exemption for 2020 is $15,000.
  • If you pass away within three years of transferring the life insurance policy to the trust, the policy will likely become part of your estate from a tax perspective. This is a policy that’s meant to make sure you don’t avoid having your heirs pay taxes by giving away assets as deathbed gifts.

Are Life Insurance Living Benefits Taxed?

Many life insurance policies come with the option of accelerating a portion of your death benefit if you become terminally or chronically ill. This option is helpful as severe illnesses often come with incredibly high hospital and treatment costs. If you are diagnosed with an illness and decide to receive accelerate your death benefit, it’s typically not taxable. From a tax perspective, it’s essentially viewed as you being the beneficiary to a life insurance payout.

Taxes on Life Insurance Dividend Payments & Cash Value

If you have permanent life insurance from a mutual insurance company, you may receive periodic dividends from the company. With mutual insurance companies, the policyholders are essentially the owners, so the company often distributes excess income in the form of annual dividends. Unless the amount of money you receive in dividends exceeds the amount you’ve paid in premiums, life insurance dividend payments are not taxable.

In addition, with permanent insurance policies, each time you pay premiums, a portion of the premium goes towards the policy’s cash value. The cash value is essentially how much money you would receive if you decided to surrender the policy to the insurer. Its growth is tied to interest rates set in the policy terms and is tax-deferred.

You can also take a tax-free loan from the insurer using the policy’s cash value as collateral, so long as the loan doesn’t exceed the cash value. However, if the loan amount exceeds the cash value, the policy might lapse and you would have to pay taxes on the loan.

Transfer for Value Rule & Taxes on Life Insurance Settlements

If you have a life insurance policy in place and decide you no longer need it, perhaps you don’t have kids and your spouse died, you may be able to get a life insurance settlement. In a life insurance settlement, a third party pays you a certain amount of money to become the policyholder and beneficiary, and they take over paying premiums.

The transfer for value rule essentially says that, when you pass away, the third party would have to pay taxes on the life insurance death benefit. However, they don’t pay income taxes on the entire amount. The taxable amount would be the death benefit minus the value of whatever was paid to you, as well as any amount paid in premiums since they acquired the policy.

As the seller, you would also be subject to taxes on the sale of your life insurance policy. A portion of the life insurance settlement will be taxable as income and the rest will be taxed as capital gains. Here’s how you can approximate how a life insurance settlement would be taxed:

  • Portion Taxed as Income – This is calculated as the policy’s cash value minus the amount you’ve paid in premiums. Since term life insurance policies don’t have a cash value, this figure would be zero.
  • Portion Taxed as Capital Gains – First, you determine your total gain on the settlement by subtracting the total premium you’ve paid from the settlement you’ve received. You then subtract the amount that is subject to income tax, the previous result, to arrive at the portion that is taxable as capital gains.
  • Example: – Let’s assume you sold your life insurance policy, which had a cash value of $150,000 for a $200,000 settlement. Furthermore, you’d already paid $125,000 in premiums. The portion that would be taxed as income would be $25,000 since that is the difference between the policy’s cash value and what you’ve paid in premiums. To calculate the portion that would be taxed as capital gains, you subtract the premiums you’ve paid from the settlement you received, leaving you with $75,000. Then, you subtract the amount that is subject to income tax, which is $25,000 in our example. The remaining $50,000 would be subject to capital gains tax.

When life insurance proceeds are taxable?

There are, however, scenarios in which life insurance proceeds may incur a tax bill.

1: You have supplemental group life insurance paid by your employer: Some employers offer group life insurance as a workplace benefit. Some even pay some or all of the cost of coverage.

If your employer pays the full premium for $50,000 in coverage or less, there is no taxation on the death benefit. The IRS considers this amount part of your regular compensation.

However, any coverage over $50,000 is treated as income and the death benefit will be taxed.

2: The insurer issues the death benefit in installments: If the beneficiary receives the death benefit in installments, there may be taxes owed. That’s because the insurer will hold the principal amount in an interest-bearing account until the death benefit is fully paid out. Although the original death benefit is tax-free, the interest that accumulates is subject to income tax.

3: There are three parties involved with the policy: Typically, the owner of the policy is also the insured, so that the same person is paying the premium and having their life insured. In this scenario, the beneficiary(s) receive the death benefit tax-free.

However, there are scenarios where one party is the insured life of the policy, a second party owns and pays the policy premiums, and a third party is the beneficiary. In this scenario, the IRS considers the death benefit a gift from the policy owner to the beneficiary.

4: You surrender a policy with cash value: If you purchase whole life or universal life insurance, your coverage will remain active as long as you pay the required premiums. In addition, your policy will build cash value beyond what is needed to support your coverage. This cash value earns interest.

When you surrender a cash value policy, you cancel the coverage. The insurer will pay you the cash value accumulated in your policy, minus any fees. Any portion of that cash value payout that exceeds the amount you paid in premium is considered income and is therefore taxable.

For example, if you surrendered a policy for which you paid $100,000 in premiums and received $120,000 in cash value, you would have $20,000 in taxable income.

5: You sell your policy: People who want a payout now can sell their life insurance policy to another party. This is called a life settlement. It’s done in situations where a policyholder can receive more money from selling the policy than by surrendering it.

In a life settlement, the buyer of the policy becomes the new policy owner and takes over paying the premiums. When you die, the new owner receives the death benefit. The goal of this settlement for the buyer is to receive a death benefit that is more than what they bought the policy for.

If you sell your policy, you may owe income tax on proceeds that exceed what you pay in premiums. In addition, you may owe capital gains taxes on proceeds that exceed the policy’s cash value.

6: The death benefit becomes part of your estate: If the value of your total estate qualifies for federal estate taxes — $11.7 million in 2021 — the IRS will include your life insurance policy payout in the value. This means the death benefit adds to your overall estate, which will increase the total amount of estate tax owed.

If you may be in this situation, you should talk to a tax professional about the implications. You may be able to transfer policy ownership before you die to another person or entity, such as a trust.

7: You take out a loan from your policy’s cash value: Depending on the company that issued your policy, you may be able to borrow up to 90 percent of the policy’s cash value at any time. When you withdraw money from a life insurance policy, it’s considered a policy loan, even if you don’t intend to repay it. And because it’s a loan, the withdrawal is not considered taxable income.

For tax purposes, borrowing money from a life insurance policy is no different than a student loan, a home equity loan, or a car loan. Since the intention is to repay the money with interest, the IRS does not consider a life insurance policy loan as income.

Depending on the provisions of your contract, you can often take as long as you wish to pay back the policy loan. You can even choose not to repay the loan and accept a lower death benefit.

Many people, in fact, buy life insurance policies in their 40s and 50s so that it builds up enough cash value that they can use to supplement their retirement income. Basically, each withdrawal from the policy for retirement income is a policy loan, which means it’s tax-free income. Those loans are generally not repaid, and whatever is left in the policy after the owner(s) passes away is the death benefit received by the beneficiaries.

Where you may end up with a tax obligation is if the insurance company has to cancel the policy.

This can occur if you borrow too much. As with other types of loans, a life insurance policy loan charges interest. If the amount you borrow accrues enough interest that the amount you owe exceeds the policy’s cash value, the insurance company will require you to repay the loan. If you are unable, the insurer cancels the policy.

The tax bill comes because you were loaned money that you are no longer repaying. You will tax on the amount of the unpaid loan that exceeds the amount of premium you paid. For example, if you had a $25,000 policy loan balance and paid $20,000 in premiums when the policy was canceled, you would owe taxes on the $5,000 difference.

8: You overpay premiums on a permanent, cash-value policy: With cash value life insurance, the IRS limits how much you can pay in premium. That’s because life insurance cash values grow tax-deferred and policy death benefits are typically tax-free. Without limits to how much premium is paid into a policy, people could use life insurance as a tax-free interest-bearing account.

Some people overfund policies beyond IRS limits anyway. This creates what the IRS calls a modified endowment contract (MEC). Once a policy is considered a MEC, it is no longer a life insurance policy by IRS standards. That means any withdrawals from the policy’s cash value above the amount of premiums paid are considered taxable income.

The death benefit of a MEC is still tax-free to the policy’s beneficiaries

Please note that the information provided here is general, and you should consult your accountant to determine how taxes would be applied in your particular financial situation.

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