Life Insurance Tax: What's The Verdict On Term Policies?

Life insurance is generally not taxable, but there are some exceptions. If you're a beneficiary, you may wonder if you need to pay taxes on what you're paid. In most cases, you don't need to pay taxes on the life insurance death benefit you receive, especially if it's a lump sum. However, there are some specific scenarios where you may have to pay federal or state taxes. For example, if the life insurance policy is included in the deceased's estate and the value exceeds the federal estate tax threshold, estate taxes must be paid on the amount over the limit. Another scenario is if you choose to receive the death benefit as an annuity; any interest accrued by the annuity account may be subject to taxes. It's important to consult a tax advisor about your unique situation to understand the tax implications of your life insurance policy.

Are term life insurance payouts taxable?

Life insurance payouts are generally not taxable. When the policyholder of a life insurance policy passes away, the proceeds, or death benefits, are paid to the named beneficiary or beneficiaries. This 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. Here are some examples:

Payout structure

Lump-sum payments are generally received by the beneficiary tax-free. However, if the payout is set up to be paid in multiple payments, these payments can be taxable. For example, if a beneficiary chooses to receive their payout as an annuity (a series of payments over several years), any interest accrued by the annuity account may be subject to taxes.

Policyholder has withdrawn money or taken out a loan

Some life insurance policies, such as whole life insurance, allow the policyholder to withdraw money or take out a loan against the policy. If the money withdrawn or loaned is more than the total amount of premiums paid, the excess may be taxable.

Surrendering your policy

If you surrender your life insurance policy, the amount you paid into your policy (the cash basis) that you get back is considered a tax-free return of your principal. However, any funds over your policy's cash basis will be taxed as regular income.

Employer-paid group life plan

In some cases, an employer-paid group life plan that pays out more than $50,000 may be taxable according to the Internal Revenue Service (IRS). This is because the IRS considers the life insurance premiums your employer pays to be part of your compensation.

When a death benefit and the total value of the deceased's estate exceeds limits

If life insurance proceeds are included as part of the deceased's estate and together exceed the federal estate tax threshold, estate taxes must be paid on the proceeds over the allowed limit. The federal estate tax exemption limit was $13.61 million for an individual in 2024.

Are there tax implications for beneficiaries?

Life insurance payouts are usually tax-free for beneficiaries. However, there are certain scenarios where a beneficiary may have to pay federal or state taxes.

Lump Sum vs Installments

If the beneficiary receives the payout as a lump sum, it is generally tax-free. However, if they choose to receive the payout in installments or as an annuity, any interest accrued on the annuity account may be subject to income tax.

Estate Taxes

If the life insurance policy goes into the estate of the deceased and the value of the estate exceeds the federal estate tax threshold, estate taxes must be paid on the amount above the limit. The federal estate tax exemption limit was $13.61 million for an individual in 2024. Some states also have their own estate or inheritance taxes, with varying exemption limits.

Policy Owner's High Net Worth

If the policy involves three different people—the insured, the policy owner, and the beneficiary—and the policy owner has a high net worth, the death benefit may be subject to gift tax. This is known as the "Goodman triangle." However, this tax is only due if the policy owner's estate, including any gifts exceeding $18,000 per recipient per year, is worth more than $13.61 million.

Employer-Paid Group Life Plan

If the life insurance is an employer-paid group life plan, and the coverage exceeds $50,000, the premiums for coverage over $50,000 are subject to income taxes.

Is term life insurance subject to estate tax?

Life insurance payouts are generally not subject to income taxes or estate taxes. However, there are certain exceptions.

If the life insurance policy is included in the deceased's estate and the value of the estate exceeds the federal estate tax threshold, estate taxes must be paid on the amount that exceeds the limit. The federal estate tax exemption limit was $13.61 million for an individual in 2024. Some states also assess inheritance or estate taxes, depending on the estate's value and where the deceased lived.

If the life insurance policy has no named beneficiaries, the proceeds may be included in the deceased's estate. In this case, if the total taxable value of the deceased's assets exceeds the federal estate tax threshold, the IRS will levy an estate tax. The payout could push the estate's total taxable value over the limit, and any heirs would have to pay an estate tax on any assets above the threshold within nine months of the death.

If the life insurance payout is issued in installments, the beneficiary will not pay taxes on the benefit itself but will be responsible for paying income taxes on any interest accrued.

If the payout is set up to be paid in multiple payments, the payments can be taxable. For example, an annuity paid regularly over the life of the beneficiary may be subject to taxes.

If the life insurance policy is owned by a third party, the beneficiary may have to pay taxes on the payout.

Do employer-paid group term life plans impact taxes?

Employer-paid group term life insurance is a form of term life insurance protection for a group of employees. It is often used by employers to reward employees with fringe benefits. As employees are insured as a group, the overall cost is less expensive than it would be for individual policies.

The coverage must be offered to all eligible employees, for example, those who have worked a certain number of hours per week or have been employed for a specified length of time. A participating employee continues to be covered as long as they remain employed by the company. The benefit is typically based on a multiple of the employee's salary, and the employer can exclude other forms of compensation, such as bonuses and commissions.

According to the Internal Revenue Service (IRS), the first $50,000 of group term life insurance coverage that an employer provides is excluded from taxable income and doesn't add anything to the employee's income tax bill. This is outlined in IRC section 79, which provides an exclusion for the first $50,000 of coverage. There are no tax consequences if the total amount of such policies does not exceed this figure.

However, the cost of group term coverage in excess of $50,000 is considered taxable income for the employee. This is included in the taxable wages reported on Form W-2 and is subject to payroll taxes, as well as income tax. The taxable portion of this fringe benefit is determined using a table prepared by the IRS, which takes into account the employee's age.

In summary, employer-paid group term life plans can impact taxes when the coverage exceeds $50,000. The portion above this threshold is considered taxable income for the employee and must be included in their taxable wages.

Are there tax consequences for policy surrender?

Surrendering your life insurance policy means you're terminating the policy. You don't want or need it anymore, so you're cancelling it to get the cash surrender value. This option usually applies to permanent life insurance policies, such as whole life or universal life.

Term life insurance does not carry any cash value, which means there is no surrender value to the contract. If you cancel the policy, you won't get anything back.

If you surrender a permanent life insurance policy, you may receive more money than the policy's cost basis. In this case, the excess may be subject to income taxes. However, 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.

The Internal Revenue Service (IRS) considers the surrender of a life insurance policy a taxable event if the surrender value is more than the premiums you've paid. The difference between the cash surrender value and the total premiums paid is considered taxable income. The amount you'll owe in taxes depends on your marginal tax rate for the year, often called your income tax bracket.

Surrendering your policy may trigger tax consequences if any of the following occur:

• You receive more funds than the policy's cost basis.
• You have outstanding policy loans that exceed the policy's cost basis.
• Your cost basis changed while you had the policy, such as reducing the death benefit or adding riders.

Before surrendering your policy, it's important to consult with a tax expert and financial advisor to understand the potential tax implications and explore alternative options.

Frequently asked questions