One of the primary upsides to life insurance is that the payout is made to your beneficiaries tax-free. Since life insurance death benefits can be in the millions of dollars, it’s a significant advantage to buying (and receiving) life insurance. Is Life Insurance Payout Taxable? When are life insurance proceeds tax-free? Continue reading below as we answer every question below.
But there are other aspects to life insurance that won’t get past the tax man. Here’s a look at when to prepare for a tax bill.
When are life insurance proceeds tax-free?
Generally, your beneficiaries can dodge taxes in these situations.
Death benefit paid out to beneficiaries
Most people buy life insurance so they can leave money to their beneficiaries when they die. Fortunately, the death benefit isn’t considered taxable income, so the full payout will go to your beneficiaries. There’s one exception, and that’s when your estate is valued at more than $11.58 million — the IRS threshold for 2020. In this case, the proceeds of the policy will be counted as part of your estate and may be subject to federal estate taxes.
Cash value gains
If you choose a whole or universal life insurance policy, it builds cash value over time. The cash value gains are not subject to any taxation unless the policy is surrendered or transferred to another owner — a scenario referred to as a life insurance settlement.
If you decide to cancel your life insurance policy before it matures, you’re eligible to gain access to your accrued cash value minus any surrender fees. This is called a “life insurance surrender,” and as long as your settlement amount is less than the total you paid in premiums, your surrender payout is tax-free.
Early payout for chronic or terminal illness
Many life insurance policies offer an accelerated death benefit rider, which allows you to access part of your death benefit while you’re alive if you’re diagnosed with a chronic or terminal illness. You can spend this early payout of your death benefit on anything you like, such as your medical bills, long-term care or everyday expenses. The IRS defines the payout on such riders as an acceleration of death benefits, protecting them from taxation.
Annual life insurance dividends
Some big-name providers like Liberty Mutual, State Farm and New York Life are mutual insurance companies, which means they’re owned in part by their policyholders. Policyholders with these companies are eligible to receive annual dividends on the company’s profits. These dividends are not taxable, as long as your received dividend amount is not more than the sum of your premium payments in the same year.
Return of premium policy refunds
A return of premium (ROP) policy reimburses you for any premiums you paid if you outlive the policy. Since it’s a refund — and not a payment or profit — the money you receive isn’t subject to tax.
Are life insurance premiums tax-deductible?
Unfortunately premiums aren’t tax-free, even if you’re paying for an individual policy. You also can’t use a Flexible Spending Account (FSA) or Health Savings Account (HSA) to pay premiums.
When Is Life Insurance Taxable?
|Situation||What part could be taxable?|
|You withdraw money from cash value||Any amount you receive above “policy basis”|
|You surrender a policy for cash||Any amount you receive above “policy basis”|
|You take a loan against the cash value||None, as long as the policy remains in-force|
|You sell the policy through a viatical settlement||None|
|You’re a beneficiary who receives a life insurance payout plus interest||The interest amount|
|The life insurance payout goes into your estate||Any amount of the estate that’s subject to state or federal estate taxes.|
|You sell your life insurance in a viatical settlement||None|
Life Insurance Taxes FAQ
1: Are Life Insurance Premiums Taxable? The life insurance premiums you pay are not taxable. They are also not deductible on your tax return.
2: Do You Pay Inheritance Tax on Life Insurance? There is no inheritance tax on life insurance. Life insurance death benefits are paid tax-free to your life insurance beneficiaries.
3: Is There a Penalty for Cashing Out Life Insurance? If you surrender a cash value life insurance policy, the only “penalty” is that you may have to pay a surrender fee. The life insurance company will deduct the surrender fee when it sends you the money. Check your policy to find out the fee, or ask your life insurance agent. Surrendering a policy ends the life insurance coverage. A portion of the money you receive may be taxable if it includes investment gains.