Life Insurance Beneficiaries And Tax: What's The Verdict?

Life insurance is typically not taxable, but there are some notable exceptions. Generally, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income, so it isn't subject to income or estate taxes. However, there are some cases when a death benefit can be taxed. For example, if the payout is set up to be paid in multiple instalments, the payments can be taxable. If the policyholder names their estate as a beneficiary, taxes may also apply. In most cases, beneficiaries won't need to pay taxes on their life insurance payout, but it's important to be aware of the exceptions.

Interest on the benefit

In most cases, a life insurance payout is not considered taxable income and beneficiaries do not need to report the payout on their taxes. However, there are some circumstances where the beneficiary may have to pay tax on the interest accrued by the policy.

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

In addition, if the death benefit is paid out in installments and the remaining portion earns interest, that interest is also taxable. This includes specific income payouts, retained asset accounts, and lifetime or fixed-period annuities.

To avoid paying taxes on the interest, the policy owner can transfer ownership of the policy to another person or entity. They can also create an irrevocable life insurance trust (ILIT) to remove the policy from their estate. However, this type of trust cannot be revoked after it is set up.

Money paid to an estate

If the beneficiary of a life insurance policy is an estate rather than an individual, the person or people inheriting the estate may have to pay estate taxes. This is because the death benefit is included in the estate and is therefore subject to potential federal and state estate taxes if it is above the tax exemption amount.

The federal exemption amount in the United States is currently $12.92 million for a single person and almost $26 million for a married couple. There are about a dozen states with state estate taxes, and exemptions vary between $1 million and $9.1 million. If the death benefit amount is above these exemptions, any amount above the threshold would be subject to estate taxes.

If the policyholder names their estate as the beneficiary, the taxes loved ones may have to pay depend on the estate's value. Leaving items to your estate also increases the estate's value and could subject your heirs to exceptionally high estate taxes.

In 2024, estates over $13.61 million owe estate tax. According to the Internal Revenue Service (IRS), if life insurance proceeds are included as part of the deceased's estate and together exceed the federal estate tax threshold of $12.92 million (as of 2023), estate taxes must be paid on the proceeds over the allowed limit.

Payout structure

The payout structure of life insurance policies can determine whether or not beneficiaries are taxed. Typically, a life insurance benefit is paid to the beneficiary in a lump sum, which is not taxable. However, there are some exceptions.

If the beneficiary elects to receive the policy amount in installments, the benefit is placed into an account that can accrue interest. While the beneficiary will not pay taxes on the benefit itself, they will be responsible for paying income taxes on any interest accrued. 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.

In addition, if the payout is set up to be paid in multiple payments, these payments can be taxable. For instance, an annuity paid regularly over the life of the beneficiary includes proceeds and interest. These payments can be subject to taxes.

It is important to note that the death benefit of a life insurance policy is typically paid directly to the beneficiaries named. However, if the benefit is included in the estate, it may be subject to federal and state estate taxes if it exceeds the tax exemption amount.

Policyholder withdraws money or takes out a loan

If a policyholder withdraws money from their life insurance policy, this is generally not considered taxable income. However, if the amount withdrawn exceeds the cost basis (i.e., the net out-of-pocket premium payments), the excess amount may be subject to income tax. It's important to note that any interest earned on the withdrawn amount is always taxable.

For example, if a policyholder has paid $100,000 in total premiums and their policy has a cash value of $150,000, they can withdraw up to $100,000 tax-free. However, if they withdraw the full $150,000, they will have to pay income tax on the $50,000 excess. Additionally, if the withdrawn funds generate interest, this interest will be taxable.

In the case of a loan taken out against a life insurance policy, the loan amount itself is not considered taxable income, as long as it doesn't exceed the sum of the insurance premiums paid and the policy remains in effect. However, if the policy is surrendered or lapses, any outstanding loan amount will be deducted from the payout, and taxes will have to be paid on any gains made through investments.

It's worth noting that if a policy loan isn't repaid before the insured person's death, the insurance company will reduce the face amount of the insurance policy by the outstanding amount when paying the death benefit to the beneficiary.

Surrendering your policy

Surrendering a life insurance policy means cancelling the policy and receiving its surrender value, which is the cash value minus any surrender fees. If you go down this route, the coverage ends, and your beneficiaries will not receive a death benefit when you die.

You'll owe taxes on the amount you receive that's above the cost basis. If the cash surrender value you receive is higher than what you've paid in through premiums (cost basis), you can be taxed on the amount that is over what you've paid. Speak with a tax professional to determine when life insurance is taxable.

The surrender value of a policy is based on the portion of premiums that went into the cash value account, plus the interest rate paid or investment gains. From that, outstanding loans are subtracted, along with any surrender fee.

Some policies take many years to build up any substantial cash value, so you might not have much cash value anyway. Over time, surrender fees tend to decrease, so ideally, you would wait until the fee is minimal or non-existent. Plus, the longer you've held the policy, the larger the cash value portion will likely be.

If your cash surrender value is worth more than you've paid in premiums, you will need to pay income taxes on the difference.

Your beneficiaries won't receive a death benefit if you surrender your policy. So when exploring your options for taking cash value from life insurance, consider how each method will impact your long-term estate planning and goals. There may be a better option if you need cash.

Whole and universal policies accrue cash value, making them the most likely option for surrender. Depending on the type and age of the policy, they may have accrued a significant amount of cash value or not very much at all. The reason some people surrender a life insurance policy for the cash value is that it rids you of the burden of a monthly premium and potentially nets a fair amount of money for other investments or necessities.

There are two caveats to surrendering a policy, however. First, if your policy isn't very old, you may incur surrender fees, which will lessen the amount of cash you receive. Second, the gain on your policy—however much it may be—will be taxed as income. Death benefits are tax-exempt, but the cash you receive from surrendering is taxable. Consult your tax professional before making any decisions.

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