Life Insurance Payouts: Are They Taxable?

Life insurance is a financial safety net for your loved ones after you pass away. But is inheritance from life insurance taxable? In most cases, beneficiaries don't need to pay taxes on their life insurance payout, especially if they receive it as a lump sum. However, certain scenarios exist where you may have to pay federal or state taxes. For example, 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. Additionally, if the payout is set up to be paid in multiple payments, the payments can be taxable.

Are life insurance proceeds taxable?

In most cases, beneficiaries do not need to pay taxes on their life insurance payout. However, there are exceptions.

Inheritance Tax

The 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.

Income Tax

Typically, life insurance proceeds are not considered taxable income. However, if the beneficiary receives interest, they will have to pay taxes on the interest. This includes interest accrued by an annuity account, which is a series of payments over several years.

Estate Tax

If the life insurance policy goes into an estate, the payout may be included in the deceased's estate. If the value of the estate exceeds the federal estate tax threshold, estate taxes must be paid on the amount that is over the limit. As of 2024, the federal estate tax threshold is $13.61 million, and some states also assess inheritance or estate taxes.

Generation-Skipping Tax

Similarly to the estate tax, the generation-skipping tax is imposed on any assets that skip a generation. They are only enforced when they exceed the same threshold.

When There Are More Than Two Parties Involved

If a third person is involved, the beneficiary on the life insurance policy may be taxed. For example, if a mother buys her daughter a life insurance policy but names the father the beneficiary, the father would be taxed.

When You Withdraw Money from a Cash Value Life Insurance Policy

If you invest in a cash value life insurance policy, you can take out a loan or a partial withdrawal. If you opt for a partial withdrawal, you may have to surrender the policy to use the money freely. If not, that amount will be subtracted from your final life insurance payout. You shouldn’t pay taxes on life insurance cash outs that are less than what you have paid into your premium.

When You Sell a Life Insurance Policy

If you sell your life insurance policy for cash, the profit may be subject to income tax.

When You Surrender a Life Insurance Policy

If you surrender a life insurance policy, you will have to pay taxes on the life insurance cash value because it now falls under the qualifications to be income taxed.

When might you pay taxes on life insurance?

In most cases, beneficiaries don't need to pay taxes on the life insurance death benefit they receive, especially if they receive it as a lump sum. However, there are some specific scenarios where you may have to pay federal or state taxes. Here are some instances when you might pay taxes on life insurance:

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 exceeds the limit. Some states also assess inheritance or estate taxes, depending on the estate's value and the location of the deceased.

Receiving 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.

Withdrawing or Taking Out a Loan 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 your whole life insurance policy, you may receive a cash payment from the insurer. If the surrender value exceeds the cumulative premiums, you may have to pay income taxes on the excess.

Selling Your Whole Life Policy

If you sell your whole life policy to a third party, the sales proceeds may be subject to income tax if they exceed your cumulative premiums, minus the portion attributed to the cost of insurance.

Inheritance Tax

Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are currently the only states that enforce an inheritance tax, which is placed upon the recipient for any inherited cash payouts, properties, and other assets.

Generation-Skipping Tax

Similar to the estate tax, the generation-skipping tax is imposed on any assets that skip a generation and are only enforced when they exceed the same threshold.

When There Are More Than Two Parties Involved

If a third person is involved, the beneficiary on the life insurance policy may be taxed. For example, if a mother buys her daughter a life insurance policy but names the father as the beneficiary, the father would be taxed.

What are the types of tax on life insurance?

Life insurance payouts are generally not subject to income taxes or estate taxes. However, there are certain exceptions where the beneficiary may be taxed on some or all of a policy's proceeds. Here are the types of tax that may be applicable:

Inheritance or Estate Tax

If the life insurance 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 inheritance or estate taxes. The federal estate tax threshold was $12.92 million as of 2023 and $13.61 million as of 2024. However, it's important to note that some states have lower thresholds and may also assess inheritance or estate taxes depending on the estate's value and the location of the deceased's residence.

Income Tax

Although life insurance proceeds are typically not considered taxable income, there are certain scenarios where income tax may apply. If a beneficiary chooses to receive the death benefit 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 income tax.

Additionally, if you own a whole life policy, income tax may be owed if you withdraw more than your cumulative premium payments or if you surrender or sell your policy and the proceeds exceed your cumulative premiums.

Generation-Skipping Tax

Similar to the estate tax, the generation-skipping tax is imposed on any assets that skip a generation. This tax is only enforced when the value of the assets exceeds the same threshold as the estate tax.

Interest Tax

While the death benefit itself is generally not taxable, any interest accrued on the benefit before being paid out to the beneficiary may be subject to income tax. This includes situations where the policyholder elects to delay the benefit payout, and the money is held by the life insurance company, accruing interest.

When are you required to pay taxes on life insurance?

In most cases, beneficiaries are not taxed on their life insurance payout. However, there are some exceptions.

When the payout is set up to be paid in multiple payments

If the payout is set up to be paid in multiple payments, the payments can be taxable. For example, an annuity is paid regularly over the life of the beneficiary. The payments include proceeds and interest. These payments can be subject to taxes.

When the beneficiary withdraws money or takes out a loan

Some life insurance policies, such as whole life, have the benefit of earning cash/interest over time. If the beneficiary withdraws more than the total amount of premiums paid, the excess may be taxable. Similarly, if the beneficiary takes out a loan against the cash value and the loan is still outstanding when the policy is terminated or surrendered, the loan amount in excess of the cumulative premiums may be subject to income taxes.

When the beneficiary surrenders the policy

If the beneficiary surrenders their life insurance policy, they will likely receive a cash payment from the insurer. If the surrender value is more than the cumulative premiums, the excess may be subject to income taxes.

When the beneficiary sells the policy

The beneficiary can also sell their policy to a third party. If the sales proceeds exceed the cumulative premiums, the excess may be subject to income taxes.

When the life insurance policy goes into a taxable estate

If the beneficiary isn’t named in the policy, the life insurance benefits will go into a taxable estate. The first $11.7 million is not taxed at a federal level – this is the threshold. Anything above this amount is subject to being taxed.

How to avoid paying taxes on life insurance

Life insurance payouts are generally not subject to income taxes or estate taxes. However, there are certain exceptions, and there are ways to avoid paying taxes on life insurance proceeds.

Understand When Taxes May Be Payable

Firstly, it is important to understand when taxes may be payable on life insurance proceeds. Typically, the payout from a term, whole, or universal life insurance policy isn't considered part of the beneficiary's gross income and is therefore not subject to income or estate taxes. However, there are some cases when a death benefit can be taxed. These include:

• Payout structure: If the payout is set up to be paid in multiple payments, these payments may be taxable. For example, 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.
• Withdrawing or taking out a loan against a whole life policy's cash value: If you withdraw more than your cumulative premium payments or take out a loan against your whole life policy's cash value, you may have to pay income taxes on the excess.
• Surrendering your policy: If you surrender your life insurance policy, any funds over your policy's cash basis will be taxed as regular income.
• Selling your policy: If you sell your policy to a third party, if the sales proceeds exceed your cumulative premiums, the excess may be subject to income taxes.
• Estate and inheritance 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 inheritance or estate taxes.

Use an Ownership Transfer

One way to avoid paying taxes on life insurance proceeds is to transfer ownership of the policy to another person or entity. This can be done by choosing a competent adult or entity to be the new owner and obtaining the proper assignment or transfer of ownership forms from your insurance company. It is important to note that the new owner must pay the premiums on the policy, and the transfer of ownership is an irrevocable event.

Create an Irrevocable Life Insurance Trust (ILIT)

Another way to avoid taxation on life insurance proceeds is to create an ILIT. This allows the policy to be held in trust, with the proceeds not included as part of your estate. To do this, you must not be the trustee of the trust and must not retain any rights to revoke the trust. This option may be preferable if you want to maintain some legal control over the policy or ensure that all premiums are paid promptly.

Maximize Gifting

If you anticipate that your estate may be subject to estate taxes, you can maximize your gifting potential and transfer policy ownership at little or no gift-tax cost. As long as you live another three years after the transfer, your estate could save a significant amount in taxes.

Frequently asked questions