Taxes on life insurance: Here’s when proceeds are taxable
Key takeaways
- Life insurance death benefits are typically tax-free, but there are exceptions.
- Certain actions, like policy loans or payout installments, could trigger taxes.
- Regularly review beneficiaries and policy details to avoid tax complications.
- Using strategies like an irrevocable trust can help minimize potential tax liabilities.
Having a life insurance policy allows you the peace of mind of knowing that your family will have a financial safety net in case of your passing. But many people worry about whether or not life insurance is taxable, as they do not want to burden their beneficiaries with a tax bill. Luckily, in most cases, life insurance proceeds are not considered taxable income — though there are some exceptions to be aware of.
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Whole life insurance combines life insurance with an investment component.
- Coverage for life
- Tax-deferred savings benefit if premiums are paid
- 3 variations of permanent insurance: whole life, universal life and variable life include investment component
Term life insurance is precisely what the name implies: an insurance policy that is good for a specific term of time.
- Fixed premium over term
- No savings benefits
- Outliving policy or policy cancellation results in no money back
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Is life insurance taxable?
Life insurance is often seen as a reliable way to provide for loved ones after you’re gone, and one of its biggest advantages is the tax relief it offers. Typically, the death benefit your beneficiaries receive isn’t taxed as income, meaning they get the full amount to use for expenses like paying off debts, covering funeral costs or securing their future. But there are a few situations where taxes could come into play, and it’s important to know when that might happen.
For example, if your loved ones choose to receive the life insurance payout in installments instead of a lump sum, any interest that builds up on those payments could be taxed. That extra money from interest is considered taxable income, even though the original death benefit is not. Another exception occurs when a policyholder leaves the death benefit to their estate instead of directly naming a person as the beneficiary. If the estate’s total value is large enough, it may trigger estate taxes, reducing what your loved ones ultimately receive.
Cash value life insurance, like whole or universal life, also has its own tax rules. Policyholders can generally borrow or withdraw money from the policy’s cash value, and as long as they don’t take out more than they’ve paid in, those withdrawals are usually tax-free. However, if there are unpaid loans against the policy, they will be deducted from the death benefit, meaning your beneficiaries get less.
If the policy is a modified endowment contract (MEC), taxes are different. For tax purposes, withdrawals are on a last-in, first-out (LIFO) basis. This means that all withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.
These are just a few of the situations where taxes could impact your life insurance proceeds. In the sections ahead, we’ll dive deeper into more scenarios to help you fully understand how taxes might affect your life insurance and how to potentially avoid them.
Term life insurance taxation
When it comes to term life insurance, taxation is generally straightforward because there’s no cash value component involved. The primary concern with taxation revolves around the death benefit payout and certain specific situations, like selling the policy. Luckily, most of these scenarios can be avoided with proper planning. Let’s break down a few key instances when term life insurance might be taxed.
Tax trouble with interest on installments
If the death benefit from a term life insurance policy is paid out in installments rather than as a lump sum, it may come with a hidden tax surprise. The death benefit itself is typically not taxed, but any interest that accumulates on those installment payments will be taxed as regular income. If the payout is spread over time, your beneficiaries should be prepared to report the interest on their taxes.
The Goodman Triangle: When life insurance becomes a gift tax headache
A lesser-known tax issue can arise in what’s called a Goodman Triangle. This occurs when three different individuals are involved in a life insurance policy — one person is the policy owner, another is the insured and a third is the beneficiary. In this scenario, the IRS could view the death benefit as a gift from the policy owner to the beneficiary, triggering a gift tax if the amount exceeds the annual exclusion limit, which is $18,000 in 2024. To avoid this complication, many financial advisors suggest that only two parties be involved in the policy.
Selling your term life insurance policy? Be ready for income and capital gains taxes
Selling a life insurance policy, also known as a life settlement, might seem like a good option if you no longer need the coverage. However, doing so can trigger income and capital gains taxes. If you sell your policy for more than what you’ve paid in premiums, the gain on that amount could be taxed. Here’s a simplified explanation of the taxation of life insurance policy sales:
- The portion of the sale amount you receive that is equal to what you’ve paid in premiums (your “cost basis”) will not be taxed.
- The portion that exceeds your cost basis, but is less than the cash value of the policy, is subject to income tax.
- Lastly, any amount above the cash value is subject to capital tax gains.
Additionally, the new owner of the policy may face taxes on any death benefit they receive that exceeds what they paid for the policy, plus any premiums they’ve continued to pay.
Death benefit and estate taxes: What heirs need to know
If you own a term life insurance policy when you pass away, the death benefit becomes part of your taxable estate. This could push your estate’s total value above the federal estate tax exemption ($13.61 million in 2024), triggering estate taxes. While this generally impacts only high-net-worth individuals, some states have a state estate tax as well and are typically lower thresholds, so it’s important to factor that into your planning. Working with an estate planner can help minimize these tax implications and ensure your loved ones receive as much of the death benefit as possible.
Permanent life insurance taxation
When it comes to permanent life insurance policies, the tax implications can get a bit more complicated due to the cash value component. While many of the tax concerns that apply to term life insurance also apply here, there are additional considerations when dealing with withdrawals, policy loans and dividends. Let’s break down the key scenarios.
Withdrawing more than your cost basis? Get ready for income taxes
If you decide to make a withdrawal from a universal life insurance policy, it’s important to know that the IRS will only tax the portion that exceeds your cost basis (the total amount of premiums you’ve paid into the policy). The withdrawal amount up to your cost basis is tax-free, but anything above that is considered taxable income and will need to be reported.
Example:
Policy lapse with outstanding loans? It could trigger taxable income
Taking out loans against your permanent life insurance policy allows you to borrow against the cash value without immediately worrying about taxes. However, if your policy lapses — meaning it’s no longer active due to unpaid premiums or insufficient cash value — any outstanding loan balance that exceeds what you’ve paid into the policy (your cost basis) will be treated as taxable income by the IRS.
Example:
Surrendering your policy? Beware of taxes on excess cash value
Surrendering your permanent life insurance policy might seem like a good way to access immediate cash, but it can come with tax implications. When you surrender the policy, the cash surrender value (CSV) is the amount you’ll receive after any fees are deducted. However, if the CSV is higher than the amount of premiums you’ve paid into the policy (your cost basis), the excess is taxable as ordinary income.
Example:
Participating whole life policy? Interest earned on dividends is taxable
Participating whole life insurance policies sometimes pay dividends to policyholders based on the company’s financial performance. These dividends can be left in the policy to earn interest, effectively growing the policy’s cash value over time. While the dividends themselves aren’t taxed, the interest earned on those dividends is considered taxable income and must be reported. The insurance company will issue a 1099-INT at the end of the year.
Example:
How to avoid paying life insurance taxes
As we’ve discussed, while life insurance policies offer many tax advantages, there are certain situations where taxes could still come into play. Thankfully, with careful planning and consideration, many of these potential life insurance taxes can be avoided. Let’s break down some strategies you can use to help mitigate or avoid these tax scenarios:
| Strategy | How it helps avoid taxes |
|---|---|
| Choose a lump-sum payout | Keeps the death benefit income tax-free. Avoid taxable interest by steering clear of installment payments. |
| Avoid the Goodman Triangle | Prevent gift taxes by making the insured and owner or the owner and beneficiary the same person. |
| Use an irrevocable life insurance trust (ILIT) | Keeps the death benefit out of your taxable estate if certain rules are met. Make sure the policy is transferred to the ILIT at least three years before death. |
| Keep policy loans in check | Prevent taxable income from policy loans by monitoring your loan balance and ensuring the policy doesn’t lapse. |
| Transfer ownership early | Keep the policy out of your taxable estate by transferring policy ownership well in advance (more than three years before death). |
| Review beneficiaries regularly | Ensure that your estate isn’t named as the beneficiary, and name a contingent beneficiary, to prevent estate taxes. Regularly review and update beneficiaries as life changes occur. |
By carefully planning ahead and applying the strategies outlined above, you can minimize or avoid these tax implications. Whether it’s choosing the right payout option, structuring ownership correctly or ensuring timely transfers, these steps can help protect both your life insurance benefits and your loved ones from unexpected tax burdens.
Regularly reviewing your policy, especially as life circumstances change, ensures you stay on top of any potential issues. Ultimately, thoughtful planning will allow you to make the most of your life insurance policy while safeguarding your beneficiaries from avoidable tax complications.
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