In most cases, life insurance payouts, or death benefits, are not taxable when received by a beneficiary. However, certain situations may lead to taxation, such as when interest is earned on delayed payments or when the death benefit is included in the deceased’s taxable estate. Additionally, cash value withdrawals may be taxable if they exceed the premiums paid.

Key Scenarios Where Life Insurance May Be Taxable

• Lump-Sum Payouts: Generally tax-free for beneficiaries.

• Installment Payouts: Interest earned on these is taxable.

• Cash Value Withdrawals: Only the portion above premiums paid is taxable.

• Estate Taxes: If included in a taxable estate, life insurance proceeds may be subject to estate taxes.

• Policy Transfers: Selling or transferring a life insurance policy could lead to tax liabilities.

  When are life insurance proceeds taxable?

  The following situations can have different tax implications and should be considered carefully as part of an estate planning process.

  When you choose installments instead of a lump sum life insurance payout

  When a life insurance policy gets distributed in installments instead of a lump sum, it’s called a life insurance annuity. While the death benefit itself is tax-free, any interest that accrues should be reported on your tax return as income.

  When more than two people are involved in a life insurance policy

  The cliche that three is a crowd also applies to life insurance. This particular life insurance tax, sometimes referred to as a Goodman Triangle, happens when three people are involved in a life insurance policy.

  If the beneficiary, policyholder, and insured are all different people, the IRS views the insurance policy as a gift. As such, if the total benefit amount exceeds the annual gift exclusion limit, it becomes taxable.

  If you have financial gains when you sell a term life insurance policy

  If you sell a life insurance policy because you need the cash more than the insurance coverage, be prepared to pay taxes, specifically income and capital gains tax.

  Any money you recover in the sale that is equal to what you paid in life insurance premiums won’t be taxed, but any profits you make in excess of the amount of premiums is taxed as income.

  When a death benefit triggers estate taxes

  If your estate is the beneficiary of your life insurance policy, it could trigger some estate taxes. This happens when the death benefit pushes the estate’s value over a certain threshold. While the estate value threshold is quite high for federal taxes (upwards of $13.9 million for 2024 taxes), be warned that the taxable estate threshold is different for every state.

  For instance in California, there is no estate or inheritance tax, but New York levies an estate tax on high-value estates above the $6.5 million threshold.

  If the policy is employer-paid group life insurance exceeding $50,000

  If business owners choose to extend group life insurance benefits to employees over $50,000, that payout is regarded as taxable income by the IRS. Even if employees partially pay for this life insurance policy, it can be taxable as long as the employer pays any part of the premium.

  If your life insurance policies have cash value, such as universal or whole life insurance

  Permanent life insurance policies such as whole or universal life insurance have cash value, sometimes referred to as surrender value, that follows different tax rules.

  Generally, policyholders can borrow against a permanent life insurance policy’s cash value as long as those withdrawals don’t exceed the premium payments. However, if the policy loans you’re taking out inch over the line of what’s paid in premiums, that additional money is considered taxable income.

  For whole life insurance policies, dividends aren’t taxable but any interest earned on those same dividends should be reported as income to the IRS.

  Learn more: What is universal life insurance?

  4 ways to minimize tax liability on a life insurance death benefit

  To ensure your loved ones will receive the full benefit of your life insurance policy, it pays to do the following and consult a tax professional.

  1. Choose life insurance payouts in a lump sum

  It may seem like dolling out life insurance money bit by bit might help a beneficiary stay on budget, but the tax penalties likely offset any of those benefits. Choose lump sum payouts over installments or annuities to avoid tax liability.

  2. Review policies and beneficiaries regularly

  An annual update and review of your life insurance is a great way to check that you haven’t borrowed more than the policy’s cash value or paid too much in premiums, and that the beneficiaries of your policy are up to date.

  3. When in doubt, use the IRS tool on taxable life insurance proceeds

  Consulting with a tax professional to conduct estate planning is preferred, but the IRS also has an online tool that can help determine if your life insurance will provide tax-free benefits to your loved ones.

  4. Set up an irrevocable life insurance trust (ILIT)

  One way to avoid estate tax is to set up an irrevocable life insurance trust (ILIT) which ensures that upon death, proceeds of a life insurance policy will be transferred to a trust and be distributed to certain beneficiaries.

  What are some financially savvy ways to use life insurance proceeds?

  Looking for a few ways to spend a tax-free windfall responsibly? Financial advisers recommend putting the proceeds toward digging out of high-interest debt first, then focusing on building an emergency fund.

  If you’ve already got your financial ducks in a row, you can put a large life insurance payout to work in a high-yield savings account.

  Frequently asked questions about taxes and life insurance

  1. Do you have to pay taxes on life insurance?

  Generally, as a beneficiary of a life insurance policy you are not required to report the proceeds as taxable income to the IRS.

  However, there are some exceptions, so consult the IRS website if you plan to take the insurance payout in installments, you’ve sold an insurance policy at a profit, or the proceeds are from a permanent life insurance policy that has cash value.

  2. Can life insurance premiums be tax deductible?

  Life insurance premiums on personal policies are not typically tax-deductible. However, if the policy is a gift to a charitable organization or you’re a business owner and you pay premiums for an employee, those premiums may be tax-deductible. Consulting with a tax professional is the best way to decide which tax rules apply to your situation.

  3. Do life insurance proceeds pay off estate debt before being distributed to beneficiaries?

  Life insurance proceeds cannot be used to pay off any estate debts unless the beneficiary of the life insurance policy is the estate itself. This sometimes happens if no beneficiaries are identified or if the policy beneficiaries are no longer alive.

  In this case, the estate would go into probate and creditors could require the life insurance payout to cover any remaining debts from the deceased.

  Are life insurance death benefits taxable?

  Typically, no. Most death benefits are tax-free unless interest is earned or the policy is part of a taxable estate.

  Are withdrawals from cash value taxable?

  Yes, if the withdrawal exceeds the total premiums paid, the gain is taxable as income.

  Can life insurance proceeds be part of my estate?

  Yes, if the policyholder owns the policy at the time of death, the proceeds may be included in the taxable estate.

  Is the cash surrender value of life insurance taxable?

  Yes, if you surrender a life insurance policy and receive more than the amount of premiums paid, the excess is considered taxable income.

  Do life insurance beneficiaries need to report proceeds on their tax return?

  Generally, no. Life insurance proceeds are not considered taxable income and do not need to be reported unless interest is earned on installment payments.

  Can life insurance affect estate taxes?

  Yes, if the policyholder owns the policy at the time of death, the proceeds may be included in the taxable estate and could be subject to estate taxes if the estate’s value exceeds the exemption limit.

Is Life Insurance Taxable?