Life Insurance Proceeds: Taxable Or Not?

Life insurance is often seen as a reliable way to provide for loved ones after you're gone, and one of its biggest advantages is the tax relief it offers. In most cases, life insurance proceeds are not considered taxable income, but there are some exceptions to be aware of.

The death benefit your beneficiaries receive isn't usually taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs, or securing their future. However, if your loved ones choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. That extra money from interest is considered taxable income, even though the original death benefit is not.

Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate's total value is large enough, it may trigger estate taxes, reducing what your loved ones ultimately receive.

Cash value life insurance, like whole or universal life, also has its own tax rules. Policyholders can generally borrow or withdraw money from the policy's cash value, and as long as they don't take out more than they've paid in, those withdrawals are usually tax-free. However, if there are unpaid loans against the policy, they will be deducted from the death benefit, meaning your beneficiaries get less.

If the policy is a modified endowment contract (MEC), taxes are different. For tax purposes, withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

These are just a few of the situations where taxes could impact your life insurance proceeds.

• If the policy is owned by a third party, the beneficiary might be taxed.
• If the policyholder leaves the death benefit to their estate instead of naming a person as the beneficiary, and if the estate's total value is large enough, it may trigger estate taxes.
• If the policy is a modified endowment contract (MEC), withdrawals are treated as taxable income until they equal all interest earned on the contract. | | Are life insurance premiums tax-deductible? | No, life insurance premiums are typically not tax-deductible. |

Life insurance death benefits are typically tax-free

The death benefit is typically paid out in a lump sum, but beneficiaries 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.

In 2024, the federal estate tax exemption limit is $13.61 million for an individual. This means that if you die in 2024 and the total taxable value of your assets is greater than this amount, the IRS will levy an estate tax. 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, New York's estate tax kicks in after $6.94 million. Talk to a tax professional to learn how life insurance can affect estate taxes.

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 death benefit may be subject to gift tax if different people fill each of the policy’s three roles: the insured, the policy owner, and the beneficiary. 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 $18,000 a year per recipient — is worth more than $13.61 million. 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).

Life insurance payout in installments may be taxed

Life insurance proceeds are generally not taxable, but there are some exceptions. If you choose to receive the life insurance payout in installments, any interest that builds up on those payments could be taxed as regular income. This is because the death benefit is typically paid out as a lump sum, but if it is issued in installments, the insurer will hold the principal amount in an interest-bearing account. While the original death benefit is not taxable, the interest that accumulates on the payments is. Therefore, your beneficiaries should be prepared to report the interest on their taxes.

In addition, if the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, the payout could be subject to estate taxes if the estate's total value is large enough. This is because the death benefit becomes part of the taxable estate, which may push its total value above the federal estate tax exemption. While this generally only affects high-net-worth individuals, some states have lower thresholds for state estate or inheritance taxes.

It is important to note that there are ways to minimize potential tax liabilities, such as choosing a lump-sum payout, using an irrevocable trust, and regularly reviewing beneficiaries and policy details.

Life insurance payout may be subject to estate tax

Life insurance death benefits are typically tax-free, but there are exceptions. One of the primary exceptions is estate tax.

If your policy's payout causes your estate's worth to exceed $13.6 million, your heirs might be charged estate taxes. In 2024, the federal estate tax exemption limit is $13.6 million for an individual. This means that if you die in 2024 and the total taxable value of your assets is greater than this amount, the IRS will levy an estate tax.

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, New York's estate tax kicks in after $6.94 million. Talk to a tax professional to learn how life insurance can affect estate taxes.

The bottom line? If you know your estate is worth less than $13.6 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 (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 estate tax exemption is set to increase for inflation through 2025. In 2026, it will revert to a lower level—though Congress can adjust this at any time.

Cash value life insurance has its own tax rules

Cash value life insurance has its own set of tax rules. Policyholders can generally borrow or withdraw money from the policy's cash value, and as long as they don't take out more than they've paid in, those withdrawals are usually tax-free. However, if there are unpaid loans against the policy, they will be deducted from the death benefit, meaning your beneficiaries will receive less.

If the policy is a modified endowment contract (MEC), the tax rules are different. In this case, withdrawals are treated on a last-in, first-out (LIFO) basis for tax purposes. This means that all withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

Withdrawing more than your cost basis will generally trigger income taxes. The IRS will only tax the portion that exceeds your cost basis (the total amount of premiums you've paid into the policy). The withdrawal amount up to your cost basis is tax-free, but anything above that is considered taxable income and will need to be reported.

If you surrender a permanent life insurance policy, you may face surrender fees, and you will have to pay taxes on the life insurance cash value because it now falls under the qualifications to be taxed as income. The gross surrender proceeds that exceed the cost basis are included in the policyholder's income.

Participating whole life insurance policies sometimes pay dividends to policyholders based on the company's financial performance. While the dividends themselves aren't taxed, the interest earned on those dividends is considered taxable income and must be reported.

Policy loans or surrender may trigger taxes

If you take out a loan against your life insurance policy, you generally won't have to pay income taxes as long as the policy remains in force. However, if you surrender your policy or if the policy lapses, and the amount you owe exceeds what you paid in, you could potentially face a tax bill. Essentially, in that case, you would have to pay income tax on any earnings from the investment.

A life insurance policy loan is not taxable as income, as long as it doesn't exceed the amount paid in premiums for the policy and the policy remains in effect. If you surrender your policy or your policy lapses, you must pay taxes on the money that came from interest or investment gains, even if you have an outstanding loan.

The taxable amount equals the amount of the gain realised, which is any amount you received from the cash value of your policy minus the net premium cost, or the total of premiums paid minus distributions received. It is essentially the gains on the investments.

For example, if you've paid $40,000 in premiums and the cash value of your policy is $55,000, then $15,000 ($55,000 - $40,000) would represent the investment gains and would be subject to taxation if you surrendered the policy and took the cash value. If you had an outstanding loan on the policy of $20,000, you would receive a reduced cash value of $35,000 but you would still owe tax on the $15,000 in investment gains.

If a policy loan is outstanding when the policyholder dies, the beneficiary would receive a lower death benefit as a result, but that benefit would likely not be taxed.

Repaying a loan from your life insurance cash value isn't mandatory, but outstanding debt will be deducted from the death benefit. If the loan isn't paid back before the insured person's death, the insurance company will reduce the face amount of the insurance policy by what is still owed when the death benefit is paid.

If a policy loan isn’t repaid, and the unpaid loan and its interest can significantly cut into the death benefit, which can put the policy at risk of not providing enough money to beneficiaries. If the loan value goes beyond the cash value of the insurance, your policy could lapse and be terminated by the insurance company. In this case, you would owe income taxes on the overall gain in investments in your policy, regardless of the amount of the loan.

If you surrender your life insurance policy, the cash surrender value can be taxable. Any amount you receive over the policy’s basis, or the amount you paid in premiums, can be taxed as income. If you receive more funds than the policy’s cost basis, have outstanding policy loans that exceed the policy’s cost basis, or your cost basis changed while you had the policy (e.g. by reducing the death benefit or adding riders), you may trigger tax consequences.

Frequently asked questions