Withholding Tax: Does It Affect Your Life Insurance?

Life insurance is often seen as a reliable way to provide for loved ones after death, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn't taxed as income, meaning they get the full amount to use for expenses like paying off debts or covering funeral costs. However, there are a few situations where taxes may apply. For example, if your beneficiaries 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 as regular income. Additionally, if the policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary, this could trigger estate taxes if the estate's value exceeds certain thresholds. Understanding these exceptions can help beneficiaries make informed decisions and avoid unexpected tax complications.

Life insurance and income tax

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

Life insurance proceeds are not subject to income or estate taxes in most cases. However, there are certain exceptions. The type of policy you have, the size of your estate, and how the benefit gets paid out can determine if life insurance proceeds can be taxed. Be sure to consult your tax advisor about your unique situation.

If the life insurance policy goes into an estate

If the policy doesn't have any named beneficiaries, the life insurance proceeds may be included in the deceased's estate. If the value of the estate exceeds the federal estate tax threshold, which was $13.61 million as of 2024, estate taxes must be paid on the amount that's over the limit. Some states also assess inheritance or estate taxes, depending on the estate's value and where the deceased lived.

You choose to receive the death benefit as an annuity

If a beneficiary chooses to receive their payout as an annuity (a series of payments over several years) instead of a lump sum, any interest accrued by the annuity account may be subject to taxes.

You withdraw or take out a loan against your whole life policy's cash value

When you buy whole life insurance, your premium is split between a cash value account and the policy's life insurance costs. As the cash value increases, you can choose to withdraw money or take out a loan against your whole life policy. If you withdraw more than your cumulative premium payments, you may have to pay income taxes on the excess.

You surrender your whole life insurance policy

If you no longer want to keep your life insurance policy, you can surrender it to the insurance company in exchange for a cash payment. If you surrender the policy and your surrender proceeds exceed the cumulative premiums, the excess may be subject to income taxes.

You sell your whole life policy

You can also sell your policy to a third party if you no longer want it. If the sales proceeds exceed your cumulative premiums, minus the portion of your premiums attributed to the cost of insurance, the excess may be subject to income taxes.

Types of taxes on life insurance

Inheritance or estate taxes

As a beneficiary, you might have to pay inheritance or estate taxes if the policy is part of the deceased's estate, and the value of the estate exceeds the state or federal estate tax threshold.

Beneficiaries may have to pay income taxes

Beneficiaries may have to pay income taxes if they elect to receive the policy's death benefit as an annuity, since the interest accrued in the annuity account is considered taxable income. If you own a whole life policy, you may owe income tax if you sell or surrender your policy, or if you withdraw or borrow against your policy's cash value.

How to avoid paying life insurance taxes

To avoid paying any taxes on life insurance proceeds, a taxpayer will need to transfer ownership of the policy to another person or entity.

Life insurance and estate tax

Life insurance death benefits are generally tax-free, but there are exceptions. One such exception is estate tax.

The death benefit from a life insurance policy is typically not considered part of the beneficiary's gross income and is therefore not subject to income tax. However, if the payout is included as part of the deceased's estate and the total value exceeds the federal estate tax exemption threshold, estate taxes must be paid on the proceeds over the allowed limit. As of 2023, the federal estate tax exemption threshold was $12.92 million, but this is expected to decrease to $6 million in 2026.

To avoid estate tax on life insurance proceeds, the insured must ensure that the proceeds are not paid to their estate and that they do not retain any "incidents of ownership" in the policy. Incidents of ownership include rights such as the ability to change beneficiaries, assign or revoke the policy, pledge the policy as loan security, borrow against the policy's cash surrender value, or surrender or cancel the policy.

One way to avoid estate tax on life insurance proceeds is to set up an irrevocable life insurance trust (ILIT). This involves transferring the policy to the trust, along with assets that can be used to pay future premiums, or having the trust buy the insurance itself. As long as the insured does not possess any incidents of ownership, the proceeds will not be included in their estate. It is important to act early, as the insured must survive for at least three years after the policy is transferred to the trust for this strategy to be effective.

Life insurance and interest

Life insurance death benefits are typically tax-free, but there are exceptions. Certain actions, like policy loans or payout installments, could trigger taxes.

Interest on Installments

If the death benefit from a life insurance policy is paid out in installments rather than as a lump sum, it may come with a hidden tax surprise. The death benefit itself is typically not taxed, but any interest that accumulates on those installment payments will be taxed as regular income. If the payout is spread over time, your beneficiaries should be prepared to report the interest on their taxes.

Estate Taxes

If the policy doesn't have any named beneficiaries, the life insurance proceeds may be included in the deceased's estate. If the value of the estate exceeds the federal estate tax threshold, which was $13.61 million as of 2024, estate taxes must be paid on the amount that's over the limit. Some states also assess inheritance or estate taxes, depending on the estate's value and where the deceased lived.

Withdrawing or Borrowing Against Whole Life Policy's Cash Value

When you buy whole life insurance, your premium is split between a cash value account and the policy's life insurance costs. As the cash value increases, you can choose to withdraw money or take out a loan against your whole life policy. If you withdraw more than your cumulative premium payments, you may have to pay income taxes on the excess.

Surrendering Your Whole Life Insurance Policy

If you surrender the policy and your surrender proceeds exceed the cumulative premiums, the excess may be subject to income taxes. But if the surrender value is less than the cumulative premiums you paid for the policy, you likely won't pay income taxes on the cash payment you receive from the insurer.

Selling Your Whole Life Policy

You can also sell your policy to a third party if you no longer want it. If the sales proceeds exceed your cumulative premiums, minus the portion of your premiums attributed to the cost of insurance, the excess may be subject to income taxes.

Dividends

Some life insurance companies offer dividends to whole life insurance policyholders. You generally don't pay taxes on life insurance dividends. However, if you let the insurer keep your dividends in exchange for interest, then you may pay income tax on the interest.

Life insurance and beneficiaries

Life insurance is a way to provide a financial safety net for your loved ones after you're gone. The people or entities who receive the benefits from your policy are called beneficiaries. Choosing a beneficiary is a personal choice, and it's important to keep your beneficiary designations up to date as your life changes.

There are two types of beneficiaries: primary and contingent. A primary beneficiary is the person or entity first in line to receive the death benefit from your life insurance policy. Typically, this is your spouse, children, or other family members. If your primary beneficiary dies before or at the same time as you, you can name a backup beneficiary, called a secondary or contingent beneficiary, who will receive the death benefit instead.

You can choose to have one or multiple beneficiaries, and they can be family members, charitable organizations, or legal entities. If you have multiple beneficiaries, you need to specify the benefit amount or percentage each should receive.

It's important to name a beneficiary to ensure your policy's benefits are distributed as intended. If you don't name a beneficiary, the death benefit may be paid to your estate, triggering a lengthy probate process that can delay payment to your heirs.

In most cases, you can change your beneficiaries at any time. However, in certain circumstances, such as specific divorce terms or irrevocable designations, you may need your current beneficiary's consent to make changes.

To change your beneficiary, contact your insurance company and submit the new beneficiary's information, typically online or with a form. Remember to review your policy and beneficiaries regularly to avoid tax complications and ensure your intentions are carried out.

Life insurance and policy ownership

Life insurance policy ownership is an important aspect of financial planning, offering peace of mind and financial security for loved ones in the event of an unexpected death. The policy owner holds significant rights and responsibilities, including the ability to transfer ownership, modify provisions, surrender or cancel the policy, borrow against its cash value, and designate beneficiaries.

Most individuals purchase a life insurance policy on their own life, where they are named as the insured and have full control over the policy's rights, such as choosing beneficiaries and deciding on the distribution of the death benefit. This option provides the flexibility to make decisions that align with personal needs and financial goals.

However, it is also possible for someone else to own a life insurance policy on an individual if they have a financial interest in that person. This scenario is common among spouses, parents, and businesses insuring key employees or using life insurance to guarantee loan repayments. In these cases, the policy owner has the necessary permission and proof of insurable interest, demonstrating potential financial hardship if the insured dies.

Trust-owned life insurance policies are another option, where the death benefit is managed by a trust. This arrangement can be structured as an irrevocable trust, removing it from the estate and potentially reducing estate taxes. It offers a higher level of control and protection over the policy's proceeds.

The designated beneficiary, who can be an individual or an organisation, is the entity that receives the death benefit payout upon the policyholder's death. It is crucial to keep beneficiary information updated to reflect any life changes, ensuring the policy serves its intended purpose. Naming a beneficiary with an insurable interest can also help avoid potential tax consequences.

The decision to own a life insurance policy depends on the desired level of control and whether loved ones benefit from owning the policy. While most people own the policy that insures their lives, providing total control, letting others own the policy ensures they are aware of the coverage details and know how to file a claim.

Frequently asked questions