Most people purchase a life insurance policy to ensure that their loved ones will be able to cover recurring expenses, mortgage payments and funeral costs after they die. With this in mind, it’s normal to worry about how much your loved ones will be taxed on the death benefit that they receive.
Though life insurance payouts are usually not taxable, there are a few situations when the IRS will tax your death benefit or cash value of your policy. Knowing and understanding when these taxes will come into play is essential in choosing the best possible policy for your beneficiaries. Learn more about life insurance and when your benefits may be taxed with Benzinga’s guide.
Is Life Insurance Taxable?
Life insurance provides a form of protection for those you care about after you’re no longer around to provide the care. The insurance company pays your beneficiary or beneficiaries a lump sum of the money after you die, which can be used for any type of expense.
The good news is that this lump sum is usually tax-free. However, under certain circumstances, your beneficiary may need to pay taxes on the death benefit they receive.
When is Life Insurance Taxable?
Under most circumstances, a death benefit is entirely tax-free. This is because the IRS does not require life insurance proceeds to be reported as regular income and does not consider the benefits to be taxable.
However, there are a few scenarios where the benefit can be taxed. Let’s take a look at the specific circumstances that may lead to your beneficiaries paying taxes on your death benefit.
Your Beneficiary is Receiving Your Death Benefit in Installments
If the beneficiary is being paid the death benefit in installments, the insurance provider usually keeps the primary sum in an account that accrues interest over time. While the installments themselves are not taxed, any interest that is accrued on the sum of the death benefit is considered to be taxable income.
Your Death Benefit Becomes Part of Your Estate
If the total taxable value of your estate exceeds $11.7 million at the time of your death, then an estate tax is levied by the IRS. Some states have their own estate or inheritance taxes as well.
Death benefit payouts are included in your estate if you own a life insurance policy at the time of your death and your estate is valued at more than $11.7 million, according to the IRS. This is true regardless of whether you have named a beneficiary or if your estate has been named a beneficiary. If you name your estate as your beneficiary, you’ll likely have to pay estate taxes on it.
Be aware that the value of the death benefit is included when calculating the total value of your estate. This means that if you already have plenty of assets and you’re just below the $11.7 million exemption level, your death benefit may push your estate’s value over the limit, leading to estate taxes.
The easiest way to avoid this situation is to transfer ownership of the policy to someone else before you die. However, you’ll need to do so at least 3 years before you die — if you transfer the policy less than 3 years before your death, it is still considered to be part of your estate.
Your Policy Owner and Insured are Different People
The benefit might also be taxable if the 3 main roles of a policy are all filled by different people. These roles include the insured, the policy owner and the beneficiary. The insured is the person whose life is covered by the policy. The policy owner is the person who purchased the policy and owns it. The beneficiary is the person who is to receive the death benefit in the case the insured dies.
The policy owner and insured are typically the same people: you. The beneficiary is whoever you name to receive the death benefit.
In the case different people fill each role, the IRS considers the benefit to be a gift. For example, if a spouse takes out a policy to cover the life of their spouse and names their child as the beneficiary, the death benefit is technically a gift from the owner of the policy (the spouse) to the beneficiary (the child named on the policy).
Thankfully, this is covered under the gift tax, which only applies if your estate is worth more than $11.7 million at the time of your death. This means the average person probably doesn’t need to worry about paying this tax.
Is Group Life Insurance Taxable?
Group supplemental life insurance is not taxable as long as the premiums paid by the employer are less than $50,000. If the policy’s premiums exceed $50,000, it is subject to an income tax. However, only the amount that exceeds $50,000 is taxed. Income tax will not be levied if you pay the premiums yourself for a policy through work.
Are Life Insurance Dividends Taxable?
Life insurance dividends are generally not taxable because they are considered a refund of your premiums according to the IRS. The 2 instances when dividends could be subject to tax are if you put them in an account that accrues interest or if the dividends received exceed what you’ve paid in premiums. The interest accrued is taxable and the difference in the dividend and paid premiums are taxable.
Is the Cash Value of the Policy Taxable?
There are additional instances where life insurance is taxable that directly correlate to the cash value of a life insurance policy. If you have a permanent life insurance policy, this is called whole life coverage. You build a cash value, so you’ll need to consider your tax liability. If you have a term life policy, you do not accrue cash value and thus do not need to worry about excess taxes.
Let’s take a look at a few situations when you’d need to pay taxes on the cash value of your permanent life insurance policy.
You Surrender the Policy
If you surrender a life insurance policy, you’re basically canceling the contract and asking your insurance company to pay out the current cash value of the policy. The portion of your insurance contract that exceeds your original policy basis is taxable, and the IRS counts this as regular income.
You Sell The Policy
Selling a policy usually gets you more money than surrendering the policy due to the fact that the sale price of the policy is not limited to the amount of the cash value. When you sell your life insurance policy, you may be subject to income tax and capital gains tax.
An income tax is levied on proceeds that have exceeded the policy basis while a capital gains tax is levied on proceeds that have exceeded the cash value of the policy.
You Overpay Your Premiums
Another instance where the cash value withdrawals may be taxed is if you overpay your premiums. In this case, the IRS may consider the policy as a modified endowment contract (MEC).
In this case, the IRS will tax your cash value withdrawals as income, even if you’re deducting less than the policy basis. Speak with a tax professional if you’ve overpaid your premiums and decided to take a portion of your cash value.
You Take a Loan Against Your Cash Value and Don’t Pay it Back
When you take out a loan against the cash value of your policy, it is tax-deferred. You won’t have to pay taxes on a loan as long as you pay the loan back, even if the value of the loan is more than your policy basis.
However, if you don’t pay your loan back, accruing interest may cause you to owe more money than the policy is worth, and your insurance provider can cancel your policy. In this case, the insurance company would use your cash value to repay your loan, and you’ll be taxed on the amount of money you borrowed over your original policy basis.
Do You Need Life Insurance?
If you have a spouse, child or business partner, it’s worth the time to collect a few quotes from competing life insurance providers. Many men and women are surprised to learn how affordable life insurance can be — a 30-year-old woman might pay less than $15 a month for a term life insurance policy with a $250,000 death benefit. Explore your life insurance options early to save on your policy.
Frequently Asked Questions
Do you pay inheritance tax on life insurance?
There are only a few states where any type of tax may be levied on life insurance. However, if there is an outstanding loan against the policy or if your beneficiary chooses to take their payments in installments, they may need to pay federal taxes on payouts.
Are life insurance premiums taxable?
Life insurance premiums are typically not taxable and are not tax-deductible. The IRS considers life insurance to be a personal expense, and it is not required to purchase in any state.
Benzinga crafted a specific methodology to rank life insurance. To see a comprehensive breakdown of our methodology, please visit our Life Insurance Methodology page.