Jeffrey Wade
Life insurance is a financial safety net that provides peace of mind for you and your loved ones. While it is generally understood that life insurance proceeds are not taxable, there are some exceptions and complexities that beneficiaries and policyholders should be aware of. Understanding the tax implications can help beneficiaries maximize their benefits and avoid unexpected tax burdens. This is especially important when dealing with large sums of money, such as death benefits, which can be life-changing for the recipients.
| Characteristics | Values |
|---|---|
| Are life insurance proceeds taxable? | Generally, life insurance proceeds are not taxable. |
| Are life insurance proceeds taxable for beneficiaries? | Life insurance proceeds are not taxable for beneficiaries. |
| Are life insurance proceeds taxable if paid in installments? | If the life insurance proceeds are paid in installments, the principal amount is not taxable but any interest earned is taxable. |
| Are life insurance proceeds taxable if paid to the estate? | If the life insurance proceeds are paid to the estate, they may be subject to estate taxes. |
| Are life insurance proceeds taxable if the policy is sold? | If the life insurance policy is sold, the sale amount up to the cost basis is not taxable, the portion above the cost basis but below the cash value is subject to income tax, and any amount above the cash value is subject to capital gains tax. |
| Are life insurance proceeds taxable if there is a loan against the policy? | If there is a loan against the life insurance policy, the loan amount up to the cost basis is not taxable, but any amount above the cost basis is considered taxable income. |
| Are life insurance proceeds taxable if the policy is surrendered? | If the life insurance policy is surrendered, the cash surrender value up to the cost basis is not taxable, but any amount above the cost basis is considered taxable income. |
| Are life insurance proceeds taxable if there is a gain in cash value? | If there is a gain in cash value of the life insurance policy, it is not taxable for the policyholder but may be taxable for the beneficiaries if the amount received exceeds the total amount paid into the policy. |
| Are life insurance proceeds taxable for partial withdrawals from the cash value? | Partial withdrawals from the cash value of the life insurance policy are not taxable. |
| Are life insurance proceeds taxable for annual dividends? | Annual dividends from the life insurance policy are not taxable unless the total payouts exceed the amount paid in premiums in a single year. |
What You'll Learn
Interest on life insurance proceeds is taxable
Life insurance proceeds are generally not taxable if you are the beneficiary receiving them due to the death of the insured person. However, interest accrued on the proceeds is taxable and must be reported.
If the life insurance policy was transferred to you in exchange for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration you paid, any additional premiums you paid, and certain other amounts. In this case, you would generally report the taxable amount based on the type of income document you receive, such as a Form 1099-INT or Form 1099-R.
It is important to note that there are some exceptions to the rule regarding transfers for value. For example, transfers to the insured, a grantor trust of which the insured is the grantor, a partner of the insured, or a corporation in which the insured is an officer or stockholder are not treated as transfers for value.
To ensure compliance with tax laws and take advantage of any applicable exceptions, it is recommended to consult with a tax professional or financial advisor. They can provide guidance on your specific situation and help you navigate the complex world of taxation.
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Estate taxes
Life insurance proceeds are typically not taxable as income, but there are some situations in which they are taxable.
If the beneficiary of a life insurance policy is the estate rather than an individual, the person or people inheriting the estate may have to pay estate taxes. Estate taxes are incurred at the federal level and in some states. The federal estate tax exemption was $12.06 million for 2022 and $12.92 million for 2023, with a top tax rate of 40%. At the state level, the estate tax exemption amount ranges from $1 million to $7 million, and tax rates can be as high as 20%.
To avoid estate taxes, you can transfer ownership of your policy to another person or entity. This can be done by setting up an irrevocable life insurance trust (ILIT). However, if you die within three years of transferring the policy, the proceeds will be included in your estate and taxed accordingly.
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Inheritance tax
In the US, inheritance tax is a tax placed on the recipient for any inherited cash payouts, properties, and other assets. Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are currently the only states that enforce this tax.
If you inherit money from a life insurance policy, it is typically not considered taxable income. However, 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 time.
If the policyholder names an estate as the beneficiary rather than an individual, the person or people inheriting the estate might have to pay estate taxes. The estate's value increases, and it could subject heirs to exceptionally high estate taxes.
To avoid paying any taxes on life insurance proceeds, you can transfer ownership of the policy to another person or entity.
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Generation-skipping tax
The generation-skipping transfer tax (GSTT) is a federal tax on transfers of assets or property to individuals who are more than one generation below the transferor. This includes transfers from a grandparent to a grandchild or to individuals who are more than 37.5 years younger than the transferor. The GSTT was introduced in 1976 to prevent wealthy families from avoiding estate taxes at the death of each generation.
The GSTT is equal to the highest federal gift and estate tax rate at the time of transfer (40% in 2024) and is in addition to any other federal gift or estate tax that may be owed. For 2024, the federal estate, gift, and GSTT exemption is $13.61 million for each individual ($13.99 million in 2025) and $27.22 million for married couples ($27.98 million in 2025).
There are three types of taxable events that trigger the GSTT:
- Direct skips: When assets are transferred from one individual to a skip person, either outright or in trust.
- Taxable distributions: An irrevocable trust has been created and a distribution of income or principal is made by the trust to a skip person.
- Taxable terminations: An interest in property held in trust terminates, and there are no other non-skip beneficiaries.
The GSTT only applies to transfers over an exemption amount, which for 2024 is $13,610,000 per person or $27,220,000 for a married couple. Exclusions to the GSTT include an annual exclusion of $18,000 for 2024, as well as educational and medical expenses and health insurance payments made directly to the institution or insurer.
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Policy loans or payout installments
- Policy Loans: Borrowing against the cash value of a permanent life insurance policy is generally not considered taxable income. However, if the policy lapses or is surrendered with an outstanding loan, the amount that exceeds the sum of the premiums paid may be subject to income tax. In other words, any investment gains or interest accrued on the policy loan may be taxable. It is important to note that the loan itself is not taxable as long as it does not exceed the amount of premiums paid and the policy remains in effect.
- Payout Installments: If the beneficiary chooses to receive the life insurance payout in installments rather than a lump sum, any interest that accrues on those installment payments may be taxed as regular income. This is because the original death benefit is typically not taxed, but any interest generated during the period before the payout is made is considered taxable income.
- Modified Endowment Contracts (MEC): In the case of MEC policies, special tax rules apply. Withdrawals from MEC policies are treated as taxable income until they cumulatively equal all interest earnings in the contract. This is known as the last-in-first-out (LIFO) basis.
- Tax Avoidance: To avoid taxes on policy loans, it is important to monitor the loan balance and ensure that the policy remains active by paying premiums. Additionally, choosing a lump-sum payout option can help beneficiaries avoid taxable interest on installment payments.
- Estate Taxes: If the policyholder names their estate as the beneficiary instead of an individual, the value of the life insurance proceeds may be included in the taxable estate. This could trigger estate taxes, reducing the amount received by heirs.
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Frequently asked questions
Generally, the proceeds from a life insurance policy that you receive as the beneficiary are not considered gross income and do not have to be reported on your income taxes. However, any interest earned is taxable and should be reported.
Life insurance proceeds are usually tax-free, but there are exceptions. Certain actions, like policy loans or payout installments, could trigger taxes.
Using strategies like an irrevocable trust can help minimize potential tax liabilities. Transferring ownership of the policy to another person or entity can also help avoid taxes.
