Life Insurance Proceeds: Taxable Or Not?

Life insurance is a financial safety net for your loved ones after you're gone, but what about the tax implications? In most cases, beneficiaries don't pay taxes on their life insurance payout, but there are exceptions. The type of policy, estate value, and payout structure all influence whether proceeds are taxed. Lump-sum payments are generally tax-free, but interest accrued on instalments may be taxable. If the payout goes to the insured's estate instead of a named beneficiary, it could be taxable if the estate value exceeds federal and state thresholds. Understanding these nuances is crucial for beneficiaries to navigate potential tax liabilities effectively.

Interest on life insurance proceeds

Life insurance proceeds are typically not taxable as income. However, in certain situations, the beneficiary may be taxed on some or all of a policy's proceeds. This is especially true if the beneficiary receives the payout as an annuity, or a series of payments over several years. In such cases, the interest accrued by the annuity account may be subject to taxes.

If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated during that period. For example, if the death benefit is $500,000, but it earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth.

Similarly, if the beneficiary of a life insurance policy is an estate rather than an individual, the person or people inheriting the estate might have to pay estate taxes. This is because the value of the life insurance proceeds is included in the gross estate if the proceeds are payable to the estate or to named beneficiaries if the policyholder had any "incidents of ownership" in the policy at the time of their death.

To avoid paying any taxes on life insurance proceeds, a taxpayer can transfer ownership of the policy to another person or entity. This can be done by choosing a competent adult or entity to be the new owner and completing the proper assignment or transfer of ownership forms. It is important to note that the original owner must give up all rights to make changes to the policy, including changing beneficiaries, borrowing against the policy, or surrendering or cancelling it.

Another way to avoid life insurance payouts being taxed as part of an estate is to set up an irrevocable life insurance trust (ILIT). The policy owner transfers ownership of the policy to the ILIT and cannot be the trustee, but they can determine the trust beneficiary. While this effectively removes the policy from the taxable estate, there are a couple of situations in which a tax event may still occur. Firstly, if the life insurance policy's cash value is greater than the gift tax exemption, a gift tax may need to be paid when transferring ownership. Secondly, if the policy owner passes away within three years of transferring the policy to the trust, the policy will likely become part of their estate for tax purposes.

Estate and inheritance taxes

In 2024, estates over $13.61 million owe estate tax. The federal estate tax exclusion amount for 2023 is $12.92 million, and for 2022, it was $12.06 million. The top tax rate is capped at 40%.

If the payout goes directly to a named beneficiary, it is not usually considered part of the estate and is not subject to estate taxes. However, if the beneficiary is not named, the payout will go to the estate, and estate taxes may be owed.

It is important to note that federal taxes won't be due on many estates, and life insurance proceeds are not usually subject to estate or income tax.

Whole life insurance policies

Life insurance payouts are generally not taxable, and beneficiaries typically do not pay taxes on the death benefit they receive. However, there are some exceptions to this rule, and taxes may be owed in specific scenarios. Understanding the tax implications of whole life insurance policies is essential for beneficiaries and policyholders alike.

• Withdrawals and Loans: Withdrawals from the cash value account of a whole life insurance policy may be taxable if they exceed the cumulative premium payments made by the policyholder. Similarly, if a loan is taken out against the cash value and remains outstanding when the policy is terminated or surrendered, the loan amount exceeding the cumulative premiums may be subject to income taxes.
• Surrendering the Policy: If a policyholder surrenders their whole life insurance policy to the insurance company in exchange for a cash payment, the proceeds may be subject to income taxes if they exceed the cumulative premiums paid. However, if the surrender value is less than the total premiums paid, income taxes are typically not owed on the cash payment received.
• Selling the Policy: Selling a whole life insurance policy to a third party may result in income taxes if the sales proceeds exceed the cumulative premiums, minus the portion attributed to the cost of insurance.
• Dividends: Whole life insurance policies may offer dividends, which are a return on a portion of the premium dollars. While dividends themselves are generally not taxable, if the policyholder chooses to have the insurer retain the dividends in exchange for interest, the interest earned may be subject to income tax.
• Estate Taxes: If the policyholder names their estate as the beneficiary, the proceeds may be subject to estate taxes. The taxes owed depend on the value of the estate. If the estate's value, including the life insurance proceeds, exceeds the federal estate tax threshold (which was $13.61 million as of 2024), estate taxes must be paid on the excess amount.
• Interest Accumulation: If the life insurance proceeds accumulate interest, taxes are typically owed on the interest earned. This is separate from any interest accrued through an annuity payout option, which is also taxable.

To summarise, while whole life insurance policies offer permanent coverage and a savings component, it is important to understand the potential tax implications for beneficiaries and policyholders. Withdrawals, loans, policy surrender, sales, dividends, estate taxes, and interest accumulation can all trigger tax liabilities. Consulting a tax advisor is always recommended to navigate the specific circumstances and ensure compliance with tax regulations.

Dividends from permanent life insurance

There are two types of dividends: guaranteed and non-guaranteed. Guaranteed dividends are promised by the insurance company and are typically associated with higher premiums. Non-guaranteed dividends may be paid out depending on the company's financial performance, and there is a risk that no dividends will be paid in a given year. When choosing a policy, it is important to carefully review the plan's details, including how dividends are calculated and whether or not they are guaranteed. Additionally, consider the insurance company's credit rating to assess the sustainability of dividend payments.

Dividends from life insurance policies are generally not subject to income tax by the Internal Revenue Service (IRS) as they are treated as a distribution from the contract. However, if you choose to let the insurer keep your dividends in exchange for interest, you may have to pay income tax on the interest earned.

• Cash or check: The policyholder can request that the insurer send a check for the dividend amount.
• Premium deductions: The dividend can be used to offset future premiums owed.
• Additional insurance: The dividend can be used to purchase additional insurance coverage or prepay on the existing policy.
• Savings account: The policyholder can keep the dividend with the insurance company and earn interest on the amount.

Group term life insurance

According to Internal Revenue Service (IRS) Code Section 79, if an employer provides coverage over $50,000, the cost of coverage in excess of $50,000 must be included in the employee's gross income and is subject to federal income tax and Federal Insurance Contributions Act (FICA) taxes, which include Social Security and Medicare taxes. This is the case even if the employee is paying the full cost of the insurance. The taxable amount is calculated using an IRS Premium Table, based on the employee's age.

If an employer differentiates by offering different amounts of coverage to select groups of employees, then the first $50,000 of coverage may become a taxable benefit for those employees. This includes corporate officers, highly compensated individuals, or owners with a 5% or greater stake in the business.

The type of group term life insurance policy can vary between companies. Employers can determine the size of their death benefit, whether to allow employees to increase their benefit over time, and whether to make coverage available for spouses and children.

Employees may also have the option to buy additional coverage through payroll deductions. This additional coverage may require underwriting, which is a simplified process where the employee answers questions to determine eligibility instead of undergoing a physical exam.

Group term coverage is generally inexpensive, especially for younger workers. However, the rates increase with age, and most plans have rate bands where the cost of insurance automatically increases at certain ages, such as 30, 35, and 40.

Since group term life insurance is linked to ongoing employment, the coverage typically ends when an individual's employment terminates. However, some insurance companies offer the option to continue coverage by converting to an individual permanent life insurance policy, which may carry a much higher premium.

In most cases, death benefits paid to a beneficiary are not considered taxable income, so beneficiaries will not have to pay tax on that money. However, if the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a period, the beneficiary may have to pay taxes on the interest generated during that time.

Frequently asked questions