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Is Life Insurance Taxable?
By Martha C. White MONEY RESEARCH COLLECTIVE
Estate tax law is a complicated field, so it’s understandable if you’re confused about whether — or under what circumstances — you might have to pay taxes on a life insurance payout.
In nearly all situations, beneficiaries of life insurance policies don’t have to pay income tax on the death benefit. However, there are a few exceptions in which a tax obligation might apply after a policyholder’s death, and circumstances under which a policy owner might create a tax liability. Read on to learn about these conditions and what that means for your loved ones’ finances after your death.
Table of contents
- Do you pay taxes on life insurance proceeds?
- Under what circumstances is life insurance taxable?
- Is the cash value of life insurance taxable?
- What portion of the group-term life insurance is taxable?
- Life insurance taxes FAQs
- Summary
Do you pay taxes on life insurance proceeds?
In general, life insurance payouts are tax-free for the beneficiary. According to the IRS, policy death benefits are not subject to taxation because that money isn’t included in your gross income.
If you’re a beneficiary and the policyholder dies, in most cases you won’t be responsible for paying any taxes on that money if you take it as a lump sum. This holds true for term life insurance and permanent policies, such as universal life and whole life insurance.
If the policyholder has a permanent life insurance policy that includes accelerated death benefits, those benefits aren’t subject to federal income tax if the policyholder’s doctor verifies that the illness is terminal.
Under what circumstances is life insurance taxable?
There are specific instances in which life insurance beneficiaries might wind up with a tax bill after the policyholder dies.
A beneficiary may choose to delay payment of the death benefit or choose to have it paid out in installments. In these cases, the money is earning interest before it’s distributed. According to standard IRS rules for taxing interest, the beneficiary would be responsible for paying taxes on the value of that interest.
While many beneficiaries choose to take a death benefit as a lump sum, there are cases where it might make more sense not to do so, even if that triggers a tax liability. If a beneficiary chooses to receive their payout in a series of defined payments (sometimes called “annuity payments”), this can help them better manage their cash flow. It may help reduce the chances of spending down the benefit too soon, even if it generates taxable interest.
If a policyholder doesn’t name a beneficiary, or names their estate as the beneficiary, the death benefit could be taxed federally if that money makes the total estate value greater than the estate tax exemption amount (which the IRS set at roughly $12.9 million for 2023). For this reason, if you have a life insurance policy, it’s better to specify a beneficiary by name rather than have the value of that death benefit go into your estate.
State taxes
A dozen states and Washington, D.C. levy their own estate taxes. Those states are Connecticut, Illinois, Hawaii, Maine, Maryland, Massachusetts, Minnesota, New York, Rhode Island, Oregon, Vermont, and Washington. While all have an exemption, those amounts vary greatly, from $1 million in Massachusetts and Oregon to $9.1 million in Connecticut, according to the Tax Foundation.
In addition, six states have an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. (Maryland is the only state with both estate and inheritance taxes.) The distinction between the two types of taxes is that estate taxes are levied on the estate itself, while inheritance taxes are levied on the inheritors. Spouses are generally exempt, and some states also exempt other family members.
Is the cash value of life insurance taxable?
Many types of permanent life insurance policies include a cash value component, including whole life insurance, universal life insurance, variable life insurance, and indexed life insurance. When you get quotes from life insurance companies, it’s important to make sure you understand the distinctions between these policy types.
The cash value part of the policy is invested and earns interest, which the policy owner can use to withdraw, borrow from, or cover premiums. The cash value of a term life or permanent life insurance policy generally doesn’t trigger a tax liability on the part of the named beneficiary.
A policy owner can cash out or “surrender” their policy if they no longer need the coverage. The surrender value includes the policy premiums and accrued interest minus fees and any outstanding premium payments.
If the insured person accesses the policy’s cash value portion by taking a loan or withdrawing from it, they could trigger a potential tax liability depending on the amount they take from the policy.
What portion of the group term life insurance is taxable?
Group term life insurance is a benefit some employers offer. Like other forms of compensation, it can be subject to taxation, although only in certain circumstances. If a person is covered under a life insurance policy provided directly or indirectly by their employer, there can be potential tax implications for policyholders as well as beneficiaries, depending on the circumstances.
The IRS excludes the first $50,000 in coverage, meaning that no taxes apply so long as the death benefit is no more than $50,000. If the coverage is greater, it’s taxed at ordinary income rates and subject to Social Security and Medicare taxes.
If a covered individual’s employer pays for or subsidizes the cost of life insurance coverage above $50,000, that benefit is considered imputed income, which is subject to taxation. The IRS has developed imputed income tables to determine the amount of tax owed on that benefit, which an employer documents on that employee’s W-2. The amount of tax owed increases with the amount of coverage the policy provides above the $50,000 exclusion limit and the age of the covered employee.
Whether or not the employee contributes at all to the premium also changes the calculus. Life insurance that an employer wholly pays for is a more valuable perk than one to which the employee contributes. If the coverage is merely subsidized, the employee can subtract the amount they pay towards the policy premium when determining the amount of their tax obligation.
Life insurance taxes FAQs
How do you know if life insurance is tax deductible?
Generally, life insurance premiums are not tax-deductible. The IRS views the cost of life insurance like any other personal expense, such as buying clothes or electronics. A few specific situations permit limited tax deductions of premiums, such as if you bequeath a policy as a charitable gift or if you're a business owner and the business pays premiums on behalf of company executives. But in most circumstances, you can't deduct the cost of your life insurance premiums on your taxes.
Is life insurance taxable to the beneficiary?
If you receive a life insurance death benefit, you will most likely not have to pay taxes on those funds because they are not taxable income. There are some circumstances, though, under which the beneficiary of a policy might owe taxes.
The most common situations that create taxable events for beneficiaries are when a permanent life insurance policy with an invested cash value component accrues additional interest between the death of the covered person and when the beneficiary receives the payout. In these cases, the beneficiary can be responsible for paying tax on that interest.
What happens if you stop paying life insurance?
You can lose life insurance coverage if you let your policy lapse. In general, insurers will cancel a life insurance policy if you stop paying the premiums, but there are some exceptions. Term life insurance, which pays out a death benefit but does not accrue any cash value, will simply be canceled if premiums go unpaid.
Permanent life insurance policies are different. These types of policies — which include whole life insurance, universal life insurance, variable life insurance, and indexed life insurance — have a cash value component. If an insured person has sufficient cash value built up in the policy, that value can apply towards premium payments up to the amount of that accrued value.
Is the employer-paid life insurance taxable to the employee?
A worker whose life insurance is fully or partially paid for by their employer might have to pay taxes on that benefit. Group life insurance coverage is considered imputed income and becomes taxable if the death benefit exceeds $50,000.
People whose employers pay for all or part of life insurance with coverage exceeding $50,000 may find themselves responsible for taxes. An imputed income table determines the exact amount of tax owed. In this case, it's advisable to work with a tax professional who can help you assess your best course of action.
Summary of our guide
In general, beneficiaries of a life insurance policy don’t have to pay taxes on the death benefit they receive. If you have a term life insurance policy or a type of permanent policy such as whole life insurance, your loved ones won’t have to pay income tax on the policy payout.
A few exceptions might trigger tax consequences for the beneficiary, such as if they choose to take the payout in installments and the remainder of the policy value earns interest.
Life insurance policies that are legally part of your estate can trigger federal estate tax or state tax liabilities for your inheritors. If you have a high net worth, obtaining estate planning tax and legal advice is advisable so your beneficiaries won’t have a gift tax or other tax liabilities.
There can be tax obligations for life insurance offered as a perk by employers. With a couple of highly specific exceptions, life insurance premiums are not tax-deductible because they’re considered personal expenses by the IRS.
