Do You Pay Taxes On Life Insurance?

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.

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.

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.

Gifts and death benefits are some circumstances in which life insurance payouts are not taxable.

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.

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.

Editor Malori Malone contributed to this article.