Do You Have to Pay Taxes on Life Insurance?
You don't typically pay income taxes on a life insurance payout after the insured person dies.
However, you may need to pay estate taxes if the amount passed down is very large.
You may owe income and capital gains taxes if you get rid of your own policy through a life insurance settlement or cancel it and take out the cash value.
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Are life insurance benefits taxable?
Life insurance death benefits are not taxable if you choose a lump-sum, one-time payment.
However, if you get the life insurance payment in several installments, the insurance company typically pays interest on the amount they haven't paid you yet. In this case, you have to pay income tax on the interest.
Life insurance and estate tax
Estate tax rules are different depending on your relationship with the deceased person. Spouses have different rules than children, parents or non-relatives.
You can typically pass on unlimited money and belongings to your spouse without paying estate or inheritance tax. So, if you're the beneficiary of your spouse's life insurance policy, the payout isn't taxed.
If you're the beneficiary of a policy for anyone besides your spouse, the life insurance payout is usually added to the value of their estate.
This is fine if the estate's total value is less than the federal and state exemptions. Otherwise, you may have to pay estate or inheritance taxes on anything above the exemption.
- Federal estate taxes apply to an estate larger than $13.61 million per person . Anything over that amount is taxed at a rate of up to 40%. The exact percentage is based on the taxable amount of the estate.
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State estate and inheritance taxes vary by state. The minimum estate size ranges from $1 million to $7 million. Tax rates can be as high as 20%, depending on where you live.
There are 17 states, plus Washington, D.C. , with an inheritance or estate tax.
Life insurance proceeds are only considered part of an estate for tax purposes. They are not included in the estate for other purposes, such as paying creditors, unless the estate is the beneficiary or all of the beneficiaries passed away.
How do I avoid tax on life insurance proceeds?
One way to avoid estate taxes on life insurance payouts is to set up what's called an irrevocable life insurance trust (ILIT). The insured person must create the trust before they pass away.
First, the insured person must work with an attorney to set up an irrevocable trust and name someone else as the trustee, like a relative or their attorney. Then they transfer ownership of the life insurance policy to the trust.
While an ILIT is an effective way to make sure that the life insurance death benefit isn't taxable as part of the estate, there are a couple of situations in which you may still owe taxes:
- When setting up the trust, if the life insurance policy’s cash value is greater than the "gift tax exemption," the insured person may need to pay a gift tax when transferring ownership. The gift tax exemption for 2024 is $18,000. ? This means you can gift up to $18,000 per person without having to pay taxes on your gift.
- If the insured person passes away within three years of transferring the life insurance policy to the trust, the policy will likely become part of the estate from a tax perspective. This policy ensures people can't avoid having their heirs pay taxes by giving away assets as deathbed gifts.
Are life insurance living benefits taxed?
Many life insurance policies come with the option to use a portion of your death benefit if you become terminally or chronically ill. This option can be helpful, as severe illnesses often come with incredibly high hospital and treatment costs.
If you're diagnosed with a terminal or chronic illness and decide to use part of your death benefit, it’s typically not taxable.
From a tax perspective, the IRS considers this the same as you being the beneficiary of a life insurance payout.
Whole life insurance and taxes
Whole life insurance includes both a death benefit and a cash value component that grows over time. Each time you make a payment toward your whole life insurance policy, a portion of the premium goes toward the policy’s cash value.
If you surrender your policy to the insurance company, you keep its cash value despite losing the death benefit. When you surrender your policy, you are canceling your life insurance policy and withdrawing the cash surrender value.
Is the cash value of life insurance taxable?
If you cancel your whole life policy, you'll have to pay taxes on a portion of the cash value.
That's because the part of your premium that goes toward your cash value earns interest from the life insurance company. You don't have to pay taxes on the interest until you take the money out of your policy, which means it's tax-deferred. Once you take the cash out of the policy, you must pay capital gains taxes on the interest.
If you don't want to cancel your policy but need access to its cash value, you can get a tax-free loan from the insurance company using its cash value as collateral. However, if the loan amount is greater than the cash value, the policy might lapse and you would have to pay taxes on the loan.
Are life insurance policy dividends taxable?
Dividend payments on life insurance policies aren't taxable unless the dividend is more than what you paid for your policy that year.
If you have whole life insurance from a mutual insurance company, you may get dividends from the company. That's because mutual insurance companies are owned by their policyholders. So, the company often distributes excess income through annual dividends.
Taxes on life insurance settlements
If you have a life insurance policy and decide you no longer need it — perhaps you don’t have kids, and your spouse died — you may be able to get a life insurance settlement.
With a life insurance settlement, you get a cash payout by selling your policy to a third party, usually a company.
The company becomes both the policyholder and beneficiary, and they take over paying premiums.
As the seller, you must pay taxes on the money you get for selling your life insurance policy. However, term and whole life insurance are taxed differently when this happens.
Taxes on a term life insurance settlement
Taxes on a term life insurance settlement are fairly straightforward. You must pay capital gains tax on the money you get for the settlement minus the amount you've paid in premiums.
For example, say you sell your term life insurance policy for $20,000. You've owned the policy for 10 years and pay $30 per month for coverage. You would have to pay capital gains taxes on $16,400.
Taxes on a whole life insurance settlement
You must pay income and capital gains tax after a settlement if you have whole life insurance.
First, you pay income tax on your policy’s cash value minus the amount you paid in premiums. Next, you pay capital gains tax on the settlement amount minus the amount you paid in premiums.
This is important because capital gains are taxed at a lower rate than income if you’ve had your policy for more than 366 days.
Example: Let’s assume you sell your life insurance policy, which has a cash value of $150,000, for a $200,000 settlement. You already paid $125,000 in premiums.
You will pay income tax on $25,000 since that's the difference between the policy’s cash value and what you paid in premiums.
To calculate the capital gains tax, subtract the premiums you paid from the settlement amount, leaving you with $75,000. Then, subtract the amount subject to income tax, which is $25,000 in our example. The remaining $50,000 is subject to capital gains tax.
| Step one: calculating the total gain | |
| Amount received | $200,000 |
| Premium paid | - $125,000 |
| Total gain | $75,000 |
| Step two: amount subject to income tax | |
| Cash value | $150,000 |
| Premium paid | - $125,000 |
| Amount subject to income tax | $25,000 |
| Step three: amount subject to capital gains tax | |
| Total gain | $75,000 |
| Amount subject to income tax | - $25,000 |
| Amount subject to capital gains tax | $50,000 |
Tax consequences of surrendering your life insurance policy
If you cancel your life insurance policy, whether you have to pay taxes is connected to the policy’s cash value.
You won't owe any taxes if the life insurance policy’s cash surrender value is less than the amount you already paid in monthly premiums. However, if the cash surrender value is more than your premium payments, the difference is taxable as income.
Since term life insurance policies don’t have a cash value, you won't owe taxes if you cancel your policy. However, you won't get any money from the insurance company either.
Are life insurance premiums tax deductible?
Life insurance premiums aren't typically tax deductible. If you have group life insurance through your employer, you may need to pay taxes on part of your life insurance premiums.
You don't have to pay taxes if you have less than $50,000 of group and supplemental term life insurance.
However, you have to pay taxes on any coverage over $50,000. The IRS assigns you a fair market value based on your age and then deducts any premiums you pay. The difference is taxable income.
With group coverage, the insurance company balanced its risk across many people with different health backgrounds. So, if you’re unhealthy or older, you may get a much lower rate than you would get with an individual policy. This rule helps account for situations where you get a discounted rate by buying group life insurance.
Frequently asked questions
Is life insurance taxable?
Life insurance proceeds are usually not taxable as income. However, you may have to pay capital gains or income taxes if you cancel your policy and withdraw the cash value or sell your policy in a life insurance settlement.
Do beneficiaries pay taxes on life insurance benefits?
Beneficiaries may have to pay federal estate taxes if the estate's total value is more than $13.61 million. If you live in a state that charges an estate tax and the value of your estate exceeds your state's threshold (ranging from $1 million to $7 million, depending on the state) they may be subject to state tax as well. Even if your state does not charge estate taxes, beneficiaries may have to pay taxes if the state in which they live has an inheritance tax.
How much is life insurance taxed?
Most people don't have to pay taxes on a life insurance payout. However, if the estate is very large, you may have to pay federal or state estate taxes or an inheritance tax. The federal estate tax rate is up to 40%, while state estate and inheritance taxes can be as high as 20%.
Methodology
Estate tax information was sourced from the IRS.
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