Is Life Insurance Taxable?

Life insurance payouts are not taxable. However, there are a few situations when taxes may be due, such as when the beneficiary receives a death benefit in installment payments, or an estate is listed as the beneficiary instead of an individual.

Are Life Insurance Payouts Taxable?

Life insurance proceeds are not considered taxable by the Internal Revenue Service.

When your spouse or other designated beneficiary receives a life insurance payout — known as the death benefit — no income taxes are owed.

Your beneficiary will receive the full policy value and will not have money withheld by the government.

According to the Internal Revenue Service, “Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren’t includable in gross income and you don’t have to report them.”

Life insurance payouts don’t follow the same taxation rules as lottery winnings or other large lump sums. This allows your loved one to receive tax-free money upon your death to use freely.

If you didn’t name a specific beneficiary on your life insurance policy, the money will be paid out to your estate. As long as your total estate is worth less than $11.58 million in 2020, no federal taxes are owed.

When Is Life Insurance Taxable?

In a few rare situations, life insurance may involve taxation.

If you are unsure if one of these situations applies to you, it’s best to consult a trusted financial planner or tax expert.

When Three People Are Involved

A life insurance policy has three roles: The owner, the insured person and the beneficiary.

In most cases, the owner and the insured person are the same. For example, you purchase a policy for yourself and make your spouse the beneficiary.

But when three different people are involved, the insurance payout may count as a taxable gift to the beneficiary.

For example, imagine a father (the owner) purchases a life insurance policy on his wife (the insured) and makes their daughter the beneficiary.

If the wife dies, the daughter will receive a payout from the insurance company tax-free. However, the IRS will consider this a gift from the father (who owns the policy) to his daughter.

In this example, the father is the one subject to gift tax — not the daughter.

Still, any potential gift tax won’t be owed until the father dies. Even then, gift tax can be avoided if the father’s estate — including any gifts made of more than $15,000 a year per recipient — is worth less than $11.58 million.

Payout Disbursed in Installments Instead of a Lump Sum

Most life insurance payouts are released to your beneficiary in a single lump sum after you die.

However, your beneficiary may choose to delay the payout or take the money as installment payments.

In this situation, the insurance company usually holds the death benefit’s principal amount in an interest-earning account and distributes a percentage of the death benefit over time.

If these delayed payments earn interest, the interest can be taxed as income.

Keep in mind that the death benefit itself is not taxable — just the interest on installments.

When Your Estate Exceeds the Estate Tax Threshold

Life insurance payouts are made tax-free to your designated beneficiaries. But if you did not name a beneficiary, or that person proceeds you in death, the insurance money will go to your estate. Your estate includes all your assets minus debts.

At that point, the life insurance money may be subject to estate tax if your entire estate exceeds a certain amount.

This doesn’t apply to most people. An estate must be worth more than $11.58 million in 2020 to trigger the federal tax.

However, 18 states also levy their own estate tax — and those thresholds can be much lower. For example, Oregon’s estate tax kicks in after $1 million.

Even if you name a beneficiary, the IRS may still consider the insurance payout part of your taxable estate if you own the policy when you die.

One exception is if your spouse is listed as the policy’s beneficiary. Spouses are typically exempt from estate tax.

If you have a sizeable estate, a large life insurance policy may push you above estate tax limits. Any amount over state or federal exemptions will be subject to estate tax.

Whether life insurance proceeds are included as part of the taxable estate depends on who owns the policy when you die.

One way to avoid federal taxation is to transfer ownership of your policy to another person or entity, such as an irrevocable trust.

Tip
If you transfer life insurance ownership to someone else less than three years before your death, the policy is still considered part of your estate under the IRS three-year rule.

Is the Cash Value from Life Insurance Policies Taxable?

Most types of permanent life insurance — including whole life and variable life — build a cash value you can borrow against or withdraw from over time. You can also surrender some or part of your policy back to the insurance company.

If the money you withdraw from your cash value comes from premium payments you made to the insurer, you will not owe taxes. This money is known as the policy basis.

But, if you withdraw money earned from interest or investment gains, this portion is subject to income tax.

Your insurance company can tell you how much of your withdrawal or surrender is above basis and therefore taxable.

Tip
One way to access your entire cash value tax free is by withdrawing the amount you’ve already paid in premiums. Then, access the remaining cash value as a loan, which is also not taxable.
Source: Forbes

Are Life Insurance Premiums Tax Deductible?

The monthly premiums you pay to a life insurance company are considered a personal expense and are not tax deductible.

You can’t pay your premiums with money from your Health Savings Account (HSA), either.

Last Modified: September 3, 2020

6 Cited Research Articles

  1. Internal Revenue Service. (2020, July 16). Life Insurance & Disability Insurance Proceeds. Retrieved from https://www.irs.gov/faqs/interest-dividends-other-types-of-income/life-insurance-disability-insurance-proceeds
  2. Internal Revenue Service. (2020, July 15). Do I report proceeds paid under a life insurance contract as taxable income? Retrieved from https://www.irs.gov/faqs/interest-dividends-other-types-of-income/life-insurance-disability-insurance-proceeds/life-insurance-disability-insurance-proceeds
  3. Danise, A. (2020, May 27). Is Life Insurance Taxable? Retrieved from https://www.forbes.com/advisor/life-insurance/is-life-insurance-taxable/
  4. Cornell Law School Legal Information Institute. (n.d.). 26 U.S. Code § 2035.Adjustments for certain gifts made within 3 years of decedent’s death. Retrieved from https://www.law.cornell.edu/uscode/text/26/2035
  5. DaveRamsey.com. (n.d.). Is Life Insurance Taxable? Retrieved from https://www.daveramsey.com/blog/is-life-insurance-taxable
  6. Internal Revenue Service. (n.d.). Title 26 — Internal Revenue Code 2042. Retrieved from https://www.govinfo.gov/content/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleB-chap11-subchapA-partIII-sec2042.pdf