Life insurance is big business: More than 100 million adults in the U.S. have some type of life insurance, and in 2021, the nation’s policyholders paid $159.5 billion in life insurance premiums.
These policies are popular because they provide a monetary payout to designated beneficiaries when policyholders pass away. This payout helps deal with end-of-life expenses, such as funeral costs, and also offers a measure of financial security for the beneficiary.
In many cases, life insurance payouts are not taxable, but there are circumstances that may cause some (or all) of the benefits received to be considered taxable income. Learn about the basics of life insurance, examine the difference between inheritance and life insurance, and explore situations where life insurance benefits may be subject to tax.
- How Life Insurance Payouts Work
- Is Life Insurance Taxable? In Short, Sometimes
- Inheritance vs. Life Insurance Payouts
- When There May Be Tax on Life Insurance Payouts for the Beneficiary
- When There May Be Tax on Life Insurance for the Policyholder
- What Policyholders Can Do to Ensure Death Benefits Are Not Taxed
How Life Insurance Payouts Work
Life insurance payouts — also called death benefits — are made to named beneficiaries when the policyholder passes away. For example, if a policyholder names their spouse as the beneficiary, the payout goes to them. Beneficiaries can use this money however they see fit because there are no restrictions on its use. However, in most cases, death benefits are used to help pay for the deceased’s funeral and burial expenses, to help settle outstanding debts left by the policy owner, and as income replacement for dependents.
The beneficiary may also be able to choose how they want to receive the funds. Common options for payout include:
- Lump sum: With this option, the beneficiary receives the entire payout at once.
- Specific income, or installments: With this option, the beneficiary selects both the amount of each payment and when they occur
- Lifetime income, or lifetime installments: With this option, the beneficiary receives a fixed amount each year until they pass away.
Processing a life insurance claim starts by contacting the insurer to inform them of the policyholder’s death and provide copies of the death certificate. Then, follow the insurer’s process for completing a claims form and submitting any other necessary documentation and information. Benefit payouts may take anywhere from a week to a month to arrive.
Two Types to Choose From: Term and Whole Life
There are two basic types of life insurance: term and whole life. Term life policies are in force for a specific time period — the term — after which they may be renewed or canceled. Death benefits for term life policies are only paid out if the policyholder keeps up with premium payments and dies before the end of the term, which typically lasts between 10 and 30 years. If the policy is canceled or lapses, or if the policyholder outlives the term, no benefits are paid.
Whole life policies, meanwhile, are permanent life insurance policies. These are purchased once and remain in effect until the policyholder dies as long as premiums are paid, unless the policyholder chooses to surrender the policy and cancel it. Canceling whole life insurance may come with monetary penalties depending on your policy’s contract, such as a loss of the accumulated cash value within the policy.
Is Life Insurance Taxable? In Short, Sometimes
|The death benefit is part of the policyholder’s estate||Any amount over the federal estate tax exemption limit|
|The beneficiary delays collecting the death benefit||The interest earned on death benefit accounts|
|The beneficiary collects the benefits in installments instead of a lump sum||The interest earned on death benefit accounts|
|The policy owner, insured individual, and beneficiary and three different people||Any death benefit payouts received as “gifts”|
Inheritance vs. Life Insurance Payouts
While inheritance and life insurance payouts fulfill similar functions, they’re not identical.
In the case of life insurance, specific situations may result in some of the payouts being taxable, but in general, these payouts are not taxed and are paid out at the amount stipulated in the insurance contract.
When it comes to inheritance, meanwhile, there are no policies or insurance guidelines that apply. Instead, individuals specify inheritors in their will, and payouts are distributed per the instructions in that document. As a result, they’re treated differently than life insurance payments and may be subject to taxes.
The first is the inheritance tax, which applies on a state-by-state basis. Currently, 6 states collect inheritance tax:
- New Jersey
This tax is not collected by the state directly. Instead, inheritors are responsible for paying any inheritance tax levied.
Next are estate taxes. These taxes apply to the estate as a whole, which includes cash, securities, real estate, insurance, trusts, and business interests. As of 2022, the first $12,060,000 of an estate’s value is tax-free. After this threshold, the government automatically taxes 40%.
When There May Be Tax on Life Insurance Payouts for the Beneficiary
In some cases, there may be a tax on life insurance payouts for the beneficiary. Common examples include:
The death benefit is part of the policyholder’s estate
When policyholders die, their life insurance payouts are added to the value of their estate. If these payouts push the value past the estate tax exemption limit of $12.06 million, anything over the limit is taxed.
Consider a policyholder with an estate value totaling $10 million and a life insurance policy worth $2 million that names their child as the beneficiary. When the policyholder dies, the insurance policy value is added to the estate value for a total of $12 million, or $60,000 under the tax exemption limit. As a result, the estate tax does not apply.
If, however, the estate was worth $11 million with the same $2 million life insurance policy, the total value becomes $13 million, or $940,000 over the tax-exempt limit. As a result, the federal government levies a 40% estate tax on the value of the estate over $12.06 million. In this case, that’s 40% of $940,000 or $376,000, with the remaining $564,000 going to the beneficiary, along with the $12.06 million that is not subject to the estate tax.
The beneficiary delays collecting the death benefit
If the beneficiary delays in collecting the death benefit, it may be placed into an interest-bearing account. If so, any money earned as interest is considered taxable income.
The beneficiary collects the death benefit in installments instead of a lump sum
In the case where a beneficiary chooses to receive the death benefit installments rather than a lump sum, they may be subject to income tax.
This is because if the death benefit is taken as a lump sum, it is not considered income and is not reported as such. If it’s taken as installments, however, the balance yet to be paid is held in an interest-bearing account. Any interest accrued on that account is considered income and, therefore, subject to income tax.
For example, if a beneficiary chooses 10 yearly installments of $200,000 for a $2,000,000 policy and earns $50,000 in interest over that period, this $50,000 is reported as taxable income.
The policy owner, insured individual, and beneficiary are three different people
Sometimes called Goodman’s Triangle in reference to an IRS court case, tax may be applicable on life insurance death benefits if the policyholder, insured, and beneficiary are three different people.
For example, suppose a wife buys a policy for her husband and names their son as the beneficiary.
This means that the wife is the policyholder, the husband is the insured, and the son is the beneficiary. In this case, the death benefit is considered a gift rather than an insurance payout from the father to the son. As a result, the IRS gift tax applies, which requires individuals to report any gift they receive over $16,000 in a year as taxable income.
To avoid Goodman’s Triangle, eliminate the third person by ensuring the policyholder and insured are the same person.
When There May Be Tax on Life Insurance for the Policyholder
There are also situations where there may be tax on life insurance for the policyholder themselves rather than their beneficiaries.
The policyholder surrenders or sells their policy
If a policyholder chooses to surrender or sell their policy, it may be subject to tax.
In the case of surrendering a policy, the insured is effectively canceling the policy, and the insurance company pays out the policy’s cash value minus any fees or penalties for early cancellation. This value is then divided into two parts using both the cash value and the policy basis.
The policy basis is the amount the policyholder has paid into the policy. For example, if a policyholder purchases a $20,000 policy and has paid $7,500 into the policy, $7,500 is the policy basis. When the policy is surrendered, and the value is paid out, the $7,500 policy basis is not taxable. The remaining $12,500, meanwhile, is considered taxable income by the IRS.
When it comes to selling a policy, meanwhile, two taxes apply. First is income tax on any amount over the policy basis. Second is capital gains tax on any profits received that are more than the cash value of the policy.
Consider the case of a $20,000 policy sold for $30,000 — or $10,000 more than its cash value — and where the policy basis is $10,000. In this case, the policyholder would receive the $10,000 they paid in tax-free, pay income tax on the $10,000 that exceeds the policy basis and pay capital gains tax on the remaining $10,000.
The policyholder does not repay a cash value loan or withdrawal
Policyholders may choose to take a loan or make a withdrawal from the cash value of their life insurance policies. Since these cash value loans are tax-deferred, policyholders can borrow or withdraw tax-free — so long as the money is paid back. If, however, the interest on the loan or withdrawal exceeds the cash value of the loan, the insurance company may cancel the policy and use the cash value to repay the outstanding amount. If this happens, policyholders are taxed on the amount paid back that exceeds the policy basis.
Consider a policy with a cash value of $20,000 and a policy basis of $10,000. If a policyholder takes out a $15,000 loan on this policy, which is $5,000 over their policy basis, they may not have to pay taxes on this $5,000 so long as the policy is active. If, however, the interest on the loan reaches or exceeds the total cash value and the policyholder cannot pay back the loan, the cash value is used to pay off the loan and is subject to taxes on the entire $15,000 that exceeds the cash basis.
What Policyholders Can Do to Ensure Death Benefits Are Not Taxed
In general, insurance-based death benefits are not taxed. While there are specific scenarios that can change this, it is possible to prevent them or minimize their impact:
- Take the death benefit as a lump sum. Beneficiaries can avoid income taxes on the accrued interest by receiving the benefit in one payment instead of in installments.
- Make sure the policyholder and insured are the same person. Policyholders can sidestep Goodman’s Triangle by making sure that the person who pays the premiums to keep the life insurance policy active and who the policy covers is the same person.
- Pay back loans or withdrawals before they exceed the policy’s cash value. Ensuring you do not exceed your cash value can help you avoid unexpected tax bills.