Life Insurance Loan Proceeds: Taxable Or Not?

Life insurance proceeds are usually not subject to income or estate taxes, but there are exceptions. The death benefit is typically paid out in a lump sum, but if a beneficiary chooses to receive the payout in installments, the interest that accumulates on the death benefit is subject to income tax. If the payout causes your estate's worth to exceed $13.61 million, your heirs might be charged estate 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 it lapses and the amount you owe exceeds what you paid in, you would have to pay income tax on any earnings from the investment.

Are life insurance proceeds taxable for beneficiaries?

Life insurance payouts are usually tax-free, but there are exceptions. Understanding how and when these taxes apply can help you avoid any surprises.

If you are a beneficiary, don’t start spending the money in your head just yet. Some situations can lead to taxation, particularly if you earn interest on the proceeds or the policy owner had a high net worth.

A life insurance payout can be taxable in the following situations:

• The insurer issues the death benefit in installments: The death benefit is typically paid out in a lump sum, but the beneficiary 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.
• The death benefit becomes part of your estate: 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.
• The policy involves three different people: The death benefit may be subject to gift tax if different people fill each of the policy’s three roles: the insured (the person whose life the policy covers); the policy owner (the person who buys and/or owns the policy); and the beneficiary (the person who receives the death benefit if the insured party dies). In most cases, only two people are involved. 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).

Whole life insurance and most other permanent life insurance policies earn cash value over time, which you can withdraw or borrow against when you’ve built up enough and as long as the policy is active.

For the most part, this cash is tax-deferred, meaning you only pay income taxes on it if you withdraw funds from the policy. And even then, the IRS levies a tax only on the amount that exceeds the policy basis – this is the sum of what you’ve already paid in premiums, minus any dividends you receive. So as long as you withdraw less than the policy basis, the cash value is tax-free money. Any withdrawals over the policy basis are subject to income tax.

Note that withdrawing money from the policy’s cash value reduces the death benefit, leaving your beneficiaries with a lower payout.

Situations when the cash value is taxable

• You surrender the policy: When you surrender a permanent life insurance policy, you’re essentially canceling the coverage, and the insurer pays out the policy’s cash value, minus any surrender fees. The portion of the cash value that exceeds the policy basis is taxable. For example, if you surrender a $10,000 policy and the policy basis is $5,000, the IRS considers the additional $5,000 as income and taxes it accordingly. The taxable amount reflects the investment gains you earned from the policy.
• You take out a loan against the cash value: Cash value loans are tax-deferred, even if you borrow more than the policy basis. This means you can borrow against your life insurance policy, tax-free, as long as you repay it. However, if you fail to repay the loan, the tax implications can be severe. Here’s an example: Say your policy has $10,000 in cash value and the policy basis is $5,000, meaning you’ve paid $5,000 in premiums. If you take out a $9,000 loan, you don’t have to pay taxes on the additional $4,000 as long as the policy is active. But as the loan accrues interest, the amount you owe can become greater than the cash value. At this point, you must repay the loan or the insurer can cancel the policy. If the insurer cancels the policy, it typically uses cash value to repay the loan, and you pay tax on the amount that exceeds the policy basis. This is where you can run into trouble. Not only were you struggling to repay the loan, but you’re now also hit with a big tax bill. Note that if you die before paying off the loan, any amount you still owe is taken from the death benefit, which means your beneficiaries receive less money.

Are life insurance proceeds taxable if paid in instalments?

Life insurance proceeds are generally not taxable, but there are some exceptions. If you are a beneficiary receiving proceeds in instalments, any interest that builds up on those payments will be taxed as regular income. The death benefit itself is typically not taxed, but any interest that accumulates on instalment payments will be taxed.

If you are the policyholder, the rules are different. 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 it lapses, and the amount you owe exceeds what you paid in, you would have to pay income tax on any earnings from the investment.

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

Are life insurance proceeds taxable if paid into an estate?

Life insurance proceeds are generally not taxable if they are paid to beneficiaries upon the policyholder's death. However, if the policyholder's estate is the beneficiary, the proceeds are typically included in the taxable estate.

According to Section 2042 of the Internal Revenue Code, the value of life insurance proceeds insuring your life will be included in your gross estate if the proceeds are payable to your estate or if you possessed any incidents of ownership in the policy at the time of your death. Incidents of ownership include the right to change beneficiaries, assign or revoke the policy, pledge the policy as security for a loan, borrow against the policy's cash surrender value, or surrender or cancel the policy.

To avoid taxation on life insurance proceeds, it is crucial not to name your estate as the beneficiary. Instead, consider transferring ownership of the policy to another person or entity, such as an irrevocable life insurance trust (ILIT). By doing so, the proceeds will not be included in your taxable estate. However, it is important to act early, as the three-year rule applies. This rule states that gifts of life insurance policies made within three years of death are still subject to federal estate tax.

Additionally, while the life insurance proceeds themselves are typically not taxable, any interest earned on those proceeds is taxable and should be reported.

Are life insurance proceeds taxable if the policy is surrendered?

Surrendering a life insurance policy means giving up your coverage and receiving a payout. This payout is called the cash surrender value and is based on the policy's duration, growth, and assets.

The cash surrender value of a life insurance policy can be taxable. If you receive more money than you paid in premiums, this additional amount may be taxed as income. There are several scenarios that may result in tax consequences when you surrender your policy:

• You receive more funds than the policy's cost basis.
• You have outstanding policy loans that exceed the policy's cost basis.
• Your cost basis changed while you had the policy, for example, by reducing the death benefit or adding riders.

If you surrender your policy or it lapses, you must pay taxes on any money that came from interest or investment gains, even if you have an outstanding loan.

However, if you borrow from your life insurance policy, it is generally not taxable income, as long as it doesn't exceed the amount paid in premiums and the policy remains in effect.

Are life insurance proceeds taxable if the policy is sold?

Life insurance proceeds are generally not considered taxable income, but there are some situations where taxes may be incurred. If you sell your policy for more than you've paid in premiums, the gain on that amount may be taxed. Here's a breakdown of how the taxation of life insurance policy sales typically works:

• The portion of the sale amount equal to what you've paid in premiums (your "cost basis") is usually not taxed.
• The portion that exceeds your cost basis but is less than the policy's cash value is generally subject to income tax.
• Any amount above the cash value is typically subject to capital gains tax.

Additionally, the new owner of the policy may have to pay taxes on any death benefit they receive that exceeds what they paid for the policy, as well as any premiums they continue to pay.

It's worth noting that the tax implications of selling a life insurance policy can be complex, and specific rules and regulations may vary based on your location and individual circumstances. It's always a good idea to consult with a tax professional or financial advisor to get personalized advice and ensure you understand the potential tax consequences of any decisions related to your life insurance policy.

Frequently asked questions