Life Insurance Payouts: Are They Taxable Income?

Life insurance payouts are generally not taxable, but there are some exceptions. If the policy has accrued interest, taxes are usually due on the interest amount. If the policyholder names their estate as the beneficiary, taxes may apply depending on the estate's value. If the insured and the policy owner are different, taxes may also be involved. If the policy is paid out in installments, the interest accrued will be taxable. If you take out a loan against the policy's cash value and the policy lapses before you repay it, you will pay taxes on the outstanding loan amount.

Interest on proceeds

Life insurance proceeds are generally not taxable as income. However, any interest accrued on the proceeds is taxable. This interest is calculated from the date of the insured person's death to the date the insurance company sends the death benefit check to the beneficiary. The insurance company reports the interest to the Internal Revenue Service (IRS), and the beneficiary must report and pay taxes on this interest.

If the beneficiary receives the life insurance payment as a series of installments, the insurer typically pays interest on the outstanding death benefit. This is often the case when the beneficiary is a young child or someone dependent on the insured person's income. In these situations, the beneficiary is required to pay income tax on the interest.

It is important to note that the tax treatment of life insurance proceeds may vary depending on the specific circumstances and the applicable tax laws. Therefore, it is always advisable to consult with a tax professional or financial advisor for personalized advice.

Additionally, the tax implications of life insurance proceeds can be complex, especially when considering other factors such as the type of policy, ownership transfer, and estate planning. Understanding these factors can help beneficiaries make informed decisions and potentially minimize their tax liability.

Policy transferred for cash

If you are the policyholder of a life insurance policy and you surrender it for cash, the amount you receive that is more than the cost of the policy may be taxable. This is because the exclusion for the proceeds is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts.

For example, if you have paid $50,000 in premiums (your cost basis) into your policy, and the cash value has grown to $80,000, you can withdraw up to $50,000 tax-free. However, if you decide to withdraw the full $80,000, the first $50,000 is tax-free, but the remaining $30,000 would be considered taxable income and reported to the IRS.

If you surrender your policy, the cash surrender value (CSV) is the amount you’ll receive after any fees are deducted. If the CSV is higher than the amount of premiums you’ve paid into the policy (your cost basis), the excess is taxable as ordinary income.

If your policy is a modified endowment contract (MEC), withdrawals are generally taxed according to the rules applicable to annuities—cash disbursements are considered to be made from interest first and are subject to income tax, plus possibly a 10% early-withdrawal penalty if you're under 59 and a half years old at the time of the withdrawal.

If you have an outstanding loan balance against the policy, this will be treated as taxable income by the IRS if the policy lapses or is surrendered.

If you sell your policy for cash through a life settlement, the taxation of the proceeds can be complicated and it is recommended that you seek expert tax advice. In general, any gain in excess of your basis in the policy is taxed as ordinary income.

Employer-owned life insurance

The Pension Protection Act of 2006 enacted IRC § 101(j), which outlines the requirements for the death benefit of an employer-owned life insurance policy to be income tax-free. The Act states that the death benefit will not be tax-free unless the employer fulfills a specific Notice and Consent Requirement before the policy is issued. This requirement includes the following:

• The employer must notify the insured in writing of their intention to purchase the insurance on the employee's life and the maximum amount of the policy.
• The employee must provide written consent to being insured under the contract and that the coverage may continue after their employment ends.
• The employee must be informed in writing that the employer will be the beneficiary of any proceeds upon the employee's death.

If the above requirements are met, the death proceeds will be tax-free if:

• The deceased employee was employed within the last 12 months before their death.
• The proceeds are used by the employer to pay family members of the insured, to purchase or redeem a financial interest owned by the insured in the business, or to pay the insured's estate.
• At the time the insurance was issued, the insured was a director of the employer, received compensation above a certain threshold, was one of the highest-paid officers, or was among the highest-paid 35% of all employees.

It's important to note that these rules only apply to insurance contracts issued after August 17, 2006. Policies in place before this date are grandfathered and not subject to the limitations. Additionally, employers must attach Form 8925, Report of Employer-Owned Life Insurance Contracts, to their tax returns for policies issued after this date.

In terms of tax treatment, the amount considered tax-free from employer-owned life insurance proceeds is limited to the total amount of premiums paid and other amounts paid by the policyholders. Any remaining proceeds above this amount are typically subject to taxation.

Estate as beneficiary

When an estate is named as the beneficiary of a life insurance policy, the proceeds are generally included in the estate's gross income and are subject to estate taxes. This means that the person or people inheriting the estate may have to pay estate taxes on the value of the life insurance payout.

Estate taxes are an important consideration when naming your beneficiary, as they can significantly reduce the amount your loved ones ultimately receive. In the United States, the federal estate tax exemption is $12.06 million for 2022, and $12.92 million for 2023, with a top tax rate of 40%. Additionally, some states have their own estate or inheritance taxes, with thresholds ranging from $1 million to $7 million.

To avoid estate taxes, you can transfer ownership of your life insurance policy to another person or entity. This requires choosing a competent adult or entity as the new owner, who will then be responsible for paying the premiums. Alternatively, you can set up an irrevocable life insurance trust (ILIT) and transfer ownership of the policy to the trust. This allows you to maintain some legal control over the policy and ensure that premiums are paid promptly. However, it's important to act early, as any gifts of life insurance policies made within three years of death are still subject to federal estate tax.

Insured and policy owner are different

In most cases, life insurance proceeds are not taxable. However, there are some situations in which the beneficiary may have to pay taxes on the proceeds. One such situation is when the insured and the policy owner are different individuals. In this case, the IRS may conclude that the death benefit amount from the policy owner to the beneficiary is a gift, and you may have to pay gift tax on the amount.

The gift tax is typically due once the insured has passed away, but it's important to note that if the insured dies within three years of transferring ownership, the full amount of the proceeds is included in their estate as if they still owned the policy. This is known as the three-year rule and it applies to both transfers of ownership to another individual and the establishment of an irrevocable life insurance trust (ILIT).

To avoid gift tax on life insurance proceeds, you can consider the following strategies:

• Ownership transfer: By transferring ownership of the life insurance policy to another person or entity, you can change the tax treatment of the proceeds. This is because, in the event of an estate, whether life insurance proceeds are taxable is based on the policy's ownership when the insured passes away. It's important to note that the new owner must pay the premiums on the policy and that this transfer of ownership is irrevocable.
• Irrevocable life insurance trust (ILIT): By setting up an ILIT, the trust becomes the owner of the life insurance policy rather than an individual. This means that the proceeds are not included as part of the original policyholder's estate. With an ILIT, you can no longer make changes to the policy and must appoint a trustee to manage the trust according to its terms.

Frequently asked questions