- Written by Ebony J. Howard, CPA
Ebony J. Howard, CPA
Credentialed Tax Expert at Intuit
Ebony J. Howard is a certified public accountant and freelance consultant with a background in accounting, personal finance, and income tax planning and preparation. She specializes in analyzing financial information in the health care, banking and real estate sectors.Read More
- Edited ByLamia Chowdhury
Lamia Chowdhury is a financial content editor for RetireGuide and has over three years of marketing experience in the finance industry. She has written copy for both digital and print pieces ranging from blogs, radio scripts and search ads to billboards, brochures, mailers and more.Read More
- Reviewed ByEric Estevez
Owner of HLC Insurance Broker, LLC
Eric Estevez is a duly licensed independent insurance broker and a former financial institution auditor with more than a decade of professional experience. He has specialized in federal, state and local compliance for both large and small businesses.Read More
- Published: August 31, 2020
- Updated: July 6, 2023
- 8 min read time
- This page features 14 Cited Research ArticlesKey Takeaways
- Life insurance is a binding agreement between you and an insurance company that provides financial support to your loved ones when you pass away.
- The IRS doesn’t consider proceeds from death benefits as taxable income; payouts to beneficiaries of an insurance policy are usually tax-free and not counted as taxable gross income.
- If a policyholder surrenders an insurance policy to the insurance company for a cash payment, and the cash payment exceeds the policy’s cash value, the excess may be taxable.
- When the death benefit causes the estate’s value to exceed the federal estate tax exclusion of $12.92 million for individuals ($25.84 million for married couples) in 2023, estate taxes are due.
- Tax-free loans or withdrawals from the “cash value” of the insurance policy can be taken to minimize taxes and supplement retirement income.
Understanding Life Insurance and Taxation
Life insurance is a binding agreement between you and an insurance company to provide financial support to your loved ones when you pass away. When you open a life insurance policy, you pay monthly or annual premiums as specified in the contract. Upon your passing, the life insurance company pays out the accumulated money to your designated beneficiaries as a death benefit in a lump sum or regular installment payments.
Life insurance taxes depend on various factors, such as the type of policy you have, the size of your estate and who the policyholder names as the beneficiary. If the estate is named as the beneficiary, then it may be subject to taxation in accordance with federal and state rules for estate taxes. The IRS also treats excess proceeds received from the exchange of an insurance policy for cash, or something of greater value, as taxable income.
When choosing a life insurance policy, understanding its taxation helps you better plan your resources to cover any future tax liabilities you may have. It’s important for individuals in any stage of retirement that are interested in life insurance as a source of retirement income to ensure they take advantage of tax-free benefits and tax-advantaged accounts to help preserve income.
Is Life Insurance Taxable?
Generally, life insurance proceeds are not taxable when paid out as a lump sum or one-time payment. Although, when beneficiaries receive insurance payouts in installments, the insurance company will also pay interest on the remaining death benefit. This interest income received by the beneficiary is taxable as interest received and is added as income on the tax return. Payouts are also taxable if the insurance policy is surrendered to the insurer or sold to a third party for more than the cumulative premium value.
In most cases, when filing a claim for the death benefit, the beneficiary can choose if they want to receive the payout as a lump sum or in installments. After receiving the payout, the beneficiary can use the money in the manner they choose for any purpose – with no stipulations. The benefit is usually tax-free, however, it’s best to consult with a tax advisor or tax professional regarding your situation.
Life insurance benefit payouts may be taxable in an estate at the state level, just as it is at the federal level. Currently, 13 states impose an estate tax, however, the exclusion amount varies by state. For example, in Oregon, the estate tax kicks in after $1 million, whereas the exclusion estate tax is $9.1 million in Connecticut.
The IRS website provides an Interactive Tax Assistance (ITA) tool with a short questionnaire to help you determine if the life insurance proceeds you received are taxable or nontaxable.3 Minute Quiz: Can You Retire Comfortably?Take our free quiz & match with a financial advisor in 3 easy steps. Tailored to your goals. Near you or online.
When Life Insurance Payouts Are Taxable
In certain situations, life insurance proceeds must be included as taxable income. If an insurance policy is sold to a third party, surrendered to the insurance company in exchange for a cash payment or any interest is received, then it may be taxable.When They Are Taxable
- Interest Earned
- Interest income is received when beneficiaries are paid out in installments. Any interest earned on a life insurance death benefit payout must be included in the beneficiary’s taxable income and taxed accordingly.
- Surrendering the Policy
- Oftentimes, you’re allowed to surrender your life insurance policy to the insurance company for a cash payment. However, the insurance company may charge surrender fees to terminate the policy. If the cash payment received from the insurance company exceeds the policy’s cash value, the excess portion may be taxable.
- Selling the Policy
- If an individual sells their life insurance policy to a third party for an amount greater than the total premiums paid minus the portion allocated to insurance costs, any additional proceeds from the sale may be subject to income tax.
What Types of Life Insurance Payouts Are Not Taxable?
Gifts and death benefits are some circumstances in which life insurance payouts are not taxable.When They Are Not Taxable
- Death Benefits
- The IRS doesn’t consider proceeds from death benefits as taxable income, therefore payouts to beneficiaries of an insurance policy are usually tax-free and not counted as taxable gross income.
- Accelerated Death Benefits
- Accelerated death benefits allow the policyholder to receive a portion of their death benefit while they’re still alive, if terminally or chronically ill. The funds are mostly used to cover medical expenses, nursing homes, hospice care and/or a private caretaker. Accelerated death benefits are generally excludable from income for the terminally ill, however, chronically ill benefits are subject to limitations. If the accelerated death benefit is paid on the basis of costs inccured for qualified long-term care services, they are fully excludable from taxes; but if costs are paid on a per diem or periodic basis, they are excludable up to a certain limit.
In accordance with the Health Insurance Portability and Accountability Act (HIPAA), the per diem limit for 2023 is $420 a day for qualified long-term care services. Any benefit costs paid in excess will be added as taxable income.
- Life insurance proceeds given as a gift to someone are generally not taxable if they are less than the annual gift exclusion amount of $17,000 ($34,000 if married and filing jointly) in 2023, as per IRS rules. For spouses who are U.S. residents, gifting is unlimited.
How Life Insurance Affects Estate Taxes
An estate tax is a tax levied by the government on property transferred to heirs at death. When a person passes away and their estate has a value that exceeds a certain amount, estate taxes must be paid on the bequeathed property. The federal estate threshold is $12.92 million for 2023; anything above this will be taxed at the top federal statutory tax rate of 40%. State estate tax may also be levied depending on which state the decedent was living in. Typically, the property passed on in an estate is cash, stock, real estate and other assets.
Life insurance can be rather complicated as it impacts estate taxes. When the death benefit causes the estate’s value to exceed the federal estate tax exclusion of $12.92 million for individuals ($25.84 million for married couples) in 2023, estate taxes are due. The executor must file IRS Form 706 for the estate, known as United States Estate (and Generation-Skipping Transfer) Tax Return.
Beneficiaries generally don’t pay estate taxes; the estate normally pays the tax. However, if the estate distributes its taxable income to its beneficiaries and doesn’t pay enough estate tax, then the beneficiaries get taxed on that income.
If the surviving spouse is bequeathed anything in the estate, it doesn’t count towards the total gross estate and therefore isn’t subject to estate taxes. Under the unlimited marital deduction rule, a spouse is allowed to transfer an unrestricted amount of assets to their spouse free of estate and gift tax. Other deductions that reduce the estate include charitable deductions, mortgages, debt, administration losses and expenses of the estate.Never Miss Important News or Updates with Our Weekly NewsletterGet money-saving tips, hard-to-find info and tactics for a successful retirement in our free weekly newsletter.
How To Minimize Taxes on Life Insurance
One way to avoid taxation on life insurance is to transfer ownership of the policy to another person or entity such as a charitable organization or set up an irrevocable life insurance trust (ILIT). When the insurance policy is in an ILIT, this gives you the ability to exclude the death benefit from your taxable estate.
A strategy for individuals approaching or in retirement to minimize taxes is to take tax-free loans or withdrawals from the insurance policy’s cash value to supplement retirement income. A permanent (universal) or whole life insurance policy features a savings component known as a “cash value” that accumulates cash over time. You can access these funds outside the death benefit.
It’s important for individuals in all stages of retirement to consult with a financial advisor or tax professional to stay on track with financial goals and budget plans.
Frequently Asked Questions About Life Insurance and TaxesAre life insurance premiums tax-deductible?Life insurance premiums are generally not tax-deductible since it is considered a personal expense. However, under certain circumstances, premiums may be deductible. Business owners may deduct life insurance premiums paid for their employees as a business expense.What are the tax implications of life insurance policy loans and withdrawals?If the policyholder takes out a loan or withdrawal from the cash value of a life insurance policy, the loan typically isn’t taxable as income unless the loan exceeds the total premiums paid on the effective policy. The beneficiary’s payout will be reduced by the outstanding balance on the loan if left unpaid at death.
Editor Malori Malone contributed to this article.Last Modified: July 6, 2023Advertisement
14 Cited Research Articles
- Internal Revenue Service. (2023, Feb 23). Frequently Asked Questions on Estate Taxes. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-estate-taxes
- Internal Revenue Service. (2023, Feb 7). Are the Life Insurance Proceeds I Received Taxable? Retrieved from https://www.irs.gov/help/ita/are-the-life-insurance-proceeds-i-received-taxable
- Aflac. (2023). Life Insurance Trust (ILIF). Retrieved from https://www.aflac.com/resources/life-insurance/life-insurance-trust-ilit.aspx
- CCH AnswerConnect. (2023). Certain Exchanges of Insurance Policies. Retrieved from https://answerconnect.cch.com/document/arp28d14891487b6d1000ae37001b7840a5b20265/federal/irc/explanation/surrender-of-insurance-policies
- New York Life. (2023). Whole Life Insurance With Cash Value. Retrieved from https://www.newyorklife.com/articles/cash-value-life-insurance
- Internal Revenue Service. (2022, Oct 27). Frequently Asked Questions on Gift Taxes. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes
- Internal Revenue Service. (2022, Oct 26). Estate Tax. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax
- Internal Revenue Service. (2022, Sept 7). Life Insurance & Disability Insurance Proceeds. Retrieved from https://www.irs.gov/faqs/interest-dividends-other-types-of-income/life-insurance-disability-insurance-proceeds
- Fritts, J. (2022, June 21). Does Your State Have an Estate or Inheritance Tax? Retrieved from https://taxfoundation.org/state-estate-tax-inheritance-tax-2022/
- Internal Revenue Service. (2022) Archer MSAs and Long-Term Care Insurance Contracts. Retrieved from https://www.irs.gov/pub/irs-pdf/f8853.pdf
- American Association of Long-Term Care Insurance. (2020). Long-Term Insurance Tax Deductibility Rules – LTC Tax Rules. Retrieved from https://www.aaltci.org/long-term-care-insurance/learning-center/tax-for-business.php
- Office of Commissioner of Insurance and Safety Fire. (2020). Life Insurance. Retrieved from https://oci.georgia.gov/insurance-resources/life
- Internal Revenue Service. (2019, Oct 28). Instructions for Form 1099-LTC (10/2019). Retrieved from https://www.irs.gov/instructions/i1099ltc
- Internal Revenue Service. (n.d.). Form 706 United States Estate (and Generation-Skipping Transfer) Tax Return. Retrieved from https://www.irs.gov/pub/irs-pdf/f706.pdf
- Edited By