Are Life Insurance Payouts Considered Taxable Income?
Life insurance helps your family stay on their feet financially after you pass away.
As long as the policy is in good standing, the life insurance company pays out a death benefit to your beneficiaries.
Your family may use this money to replace lost income or funeral expenses.
For some families, this payout is relatively small. For others, it could be hundreds of thousands of dollars or even a million dollars or more.
One common question people have about the payment is whether they have to pay taxes on the life insurance proceeds.
The answer depends on your specific situation. That said, there is some broad guidance most people can follow.
Here’s what you need to know.
You Generally Don’t Pay Taxes
In general, most people won’t pay taxes on life insurance payouts on term life insurance policies.
The same typically goes for death benefit payouts to beneficiaries for permanent life insurance.
People get to keep the money tax-free because the IRS doesn’t consider these payments to be taxable income most of the time.
As with anything in taxes, there are exceptions that will be covered below.
Make sure none of the below situations apply to you before you start spending the death benefit paid to you.
Otherwise, you may find yourself owing a nasty tax bill and not have the money to pay it.
Keep in mind, the below is not advice for your specific situation.
Consult an expert to get advice about your particular circumstances.
Certain Situations May Require Paying Taxes
Life insurance payouts can be taxable based on several different factors.
You receive interest
Most people don’t receive interest on death benefit payouts.
They generally receive the money in a lump sum shortly after the insured person dies.
However, it is possible the death benefit payment isn’t paid out quickly.
The insurance company may have trouble finding the beneficiary.
If too much time passes, the life insurance company may have to pay interest on the death benefit.
While the death benefit usually won’t be taxable, the interest a beneficiary receives is.
Expect to receive a 1099-INT detailing the interest you must report.
Other circumstances may result in getting taxable interest, too.
The life insurance company may offer you an annuity, or payments over time, rather than a lump sum.
Some people choose this option because it helps them manage the large amount of money they’re about to receive.
They know if they get a lump sum, they may not spend it wisely.
Part of an annuity typically involves receiving interest on the balance within it.
If you don’t name beneficiaries, the life insurance death benefit gets paid to the insured person’s estate.
Most estates don’t end up paying the federal estate tax.
This is because you get a $12.06 million exemption in 2021.
This amount changes each year with inflation. Lawmakers may also adjust this amount by passing new laws.
If your life insurance death benefit becomes part of your estate and your estate’s total value falls below this amount, you don’t usually pay estate taxes.
People with large estates that have the life insurance proceeds go to the estate may be subject to the estate tax, though.
Additionally, some states have an estate tax or an inheritance tax. These may have their own exemption amounts.
Check your state’s rules to see if a state inheritance or estate tax applies to your situation.
Accessing cash value in certain circumstances
Permanent life insurance policies come with a component called cash value.
As you make premium payments, part of those payments build cash value in the policy.
If your cash value declines to zero, your policy normally lapses.
Depending on the type of policy, the cash value can grow in different ways.
Some policies have their cash value by a set interest rate.
Others have cash value change based on the performance of an index, such as the S&P 500.
No matter how your cash value changes, there’s one thing to keep in mind.
If you access cash value from the policy above your basis in the policy, you owe taxes on the difference.
The basis of your policy is generally equal to the premiums you paid in.
In many cases, this isn’t an issue as cash value doesn’t grow quickly.
It can be an issue later in the policy’s life, though.
This may also impact you if you take out a loan against the cash value.
If you don’t repay that loan, the unpaid loan is often considered taxable income.
When surrendering the policy
Permanent life insurance policies may offer you a surrender value if you decide to forfeit your policy early.
The surrender value typically isn’t large but can increase the longer you hold your policy.
If the surrender value you receive is larger than the basis of the policy, you may have to pay taxes on the difference.
The basis is usually defined as the amount you paid in premiums for the policy. It may be reduced if you received certain distributions from the policy.
These reductions could include:
- Dividend payments received
- Value of loans not paid back at the time of surrender
- Certain other circumstances depending on your policy
If you sell the policy
Most people keep their life insurance policy in force for its term.
With whole life insurance, some people cash out their policies early.
However, you may have another option. Sometimes people can sell their life insurance policies.
This means another person or company owns the policy and will likely change the beneficiary to themselves or a company.
When you die while the policy is still active, the new beneficiary receives the payout.
You may have to pay taxes when you sell the policy.
Generally, only permanent life insurance policies get sold.
If the proceeds exceed the policy’s basis, you pay income taxes on gains from the sale.
When your proceeds from the sale exceed the policy’s cash value, you must pay capital gains taxes on the difference.
Workplace group life insurance policies
You may have life insurance through your workplace.
Usually, this is in the form of a workplace benefit called group term life insurance.
You may have to pay income taxes on the premiums the employer pays on your behalf.
The IRS allows premiums for the first $50,000 of life insurance to be tax-free for the employee.
You do have to pay income taxes on the premiums for any employer-paid group life insurance over $50,000.
Let’s say your employer pays $10 per month for a $100,000 group term life insurance policy for you.
If $5 represents the cost of a $50,000 life insurance policy, the other $5 of premium payment per month would be included as compensation in your paycheck.
You won’t receive cash for this, though. Instead, you have to pay taxes on that $5.
Thankfully, the premiums for these policies are typically small enough where you won’t notice the tax impact.
If you decide to purchase additional group term life insurance coverage through work, you don’t have to pay extra taxes on those premiums.
That’s because you’re using after-tax money to pay the premiums.
Ways to Minimize Taxes on Life Insurance Death Benefits
If you may have to pay tax on life insurance proceeds, consider consulting an estate planning attorney to discuss your options.
They can help you structure your life insurance in a way to reduce taxes.
This is usually most important for high net worth individuals that may be subject to the estate tax.
It can also be important if you live in a state with an estate or inheritance tax.
You may be able to name an irrevocable life insurance trust as the beneficiary of your policy.
The trust governs how the life insurance proceeds are then distributed.
By doing this, the proceeds won’t flow through your estate and may bypass the estate tax if correctly set up.
It’s essential to set this up properly and understand all consequences.
Seek professional help from an estate planning attorney or qualified financial advisor to learn more.
Consult an Expert
As you can imagine, the potential circumstances that could exist are virtually unlimited.
Most people don’t end up paying taxes on the death benefit from a life insurance policy.
Even so, taxes are due in some instances.
For this reason, it’s best to consult a certified public accountant (CPA) when you receive a death benefit payout.
A CPA is well-versed in life insurance taxes and can advise whether you should set aside money to pay taxes.
Consulting a CPA can save you a ton of headache if you accidentally assume you don’t owe taxes but end up with a tax bill later.
The price of the advice may be well worth the peace of mind.