Is life insurance taxable?
Updated 12:07 p.m. UTC Jan. 30, 2024
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Key points
- The death benefit from life insurance is typically not taxable.
- When a death benefit is paid out in installments rather than a lump sum, however, the interest earned on the death benefit is taxable.
- Withdrawing money from the cash value of a life insurance policy could trigger income taxes.
- If you transfer your policy over to someone, a gift tax may be applied.
More often than not, life insurance pays out to your heirs tax-free. But life insurance proceeds are taxable in certain circumstances.
Here’s what you need to know about life insurance and taxes.
Ethos
Is life insurance taxable?
As a general rule, a life insurance payout is tax-free. When you die, your beneficiaries usually won’t have to pay taxes on the life insurance death benefit they receive.
However, there are situations where life insurance can trigger a tax bill.
Withdrawals from cash-value policies
Permanent life insurance policies, such as whole life or universal life, typically build a cash value that grows tax-deferred. In general, as long as you don’t touch that money, you won’t owe any taxes on your gains.
However, if you withdraw that cash from the policy, any amount that is greater than the total premiums you’ve paid toward that cash value — minus the premiums you paid for any riders — would be taxable, according to Chris Cooper, a Certified Financial Planner with 25 years of experience in the life insurance industry.
That taxable amount would be added to your taxable income — potentially pushing you into a higher tax bracket if you aren’t careful.
Death benefit installment payouts
If the beneficiary of a policy decides to delay the life insurance payout, or take the death benefit in installments rather than as a lump sum, interest may accrue.
Any earned interest paid out to the beneficiary can be taxed.
Surrendered policies
If you surrender a life insurance policy for cash, you will owe taxes on any amount that exceeds the premiums you’ve paid, minus any refunds or dividends.
You can use the IRS’ life insurance proceeds tool to figure out if the life insurance benefits you’ve received are taxable.
The death benefit is considered a gift
The IRS sees a death benefit as taxable if it is considered a gift. This is most likely to happen if the policy involves three people: the policyowner, the insured and the beneficiary.
For instance, if a wife purchases life insurance for her husband, she is the policyholder and he is the insured. They decide their daughter will be named the beneficiary of the policy. When the husband, or the insured, dies, the IRS will consider the death benefit as a taxable gift to the daughter.
This can be avoided by limiting life insurance policies to two people and ensuring the insured is also the policyholder.
Estate taxes
Ideally the death benefit of a life insurance policy will go directly to the named beneficiary, but if a beneficiary isn’t named, the death benefit goes to their estate and may be subject to federal and state estate taxes, as applicable. The same is true if the beneficiary was named but died prior to receiving the death benefit.
With the federal estate tax exemption currently over $12 million, you can leave a very large estate before your heirs potentially face estate taxes. But keep in mind that a few states have their own estate and inheritance tax guidelines. Those could be assessed in the event of a policy transfer and would be in addition to any federal estate or inheritance taxes.
Here are the states that have estate or inheritance tax laws.
State estate tax laws
| STATE | EXEMPTION | RATE |
|---|---|---|
Connecticut
| $7.1 million
| 10.8% to 12%
|
Illinois
| $4 million
| 0.8% to 16%
|
Maine
| $5.8 million
| 0.8% to 12%
|
Massachusetts
| $1 million
| 0.8% to 16%
|
Minnesota
| $3 million
| 13% to 16%
|
New York
| $5.9 million
| 3.06% to 16%
|
Oregon
| $1 million
| 10% to 16%
|
Rhode Island
| $1.6 million
| 0.8% to 16%
|
Vermont
| $5 million
| 16%
|
Washington
| $2.2 million
| 10% to 20%
|
Washington, D.C.
| $4 million
| 11.2% to 16%
|
State inheritance tax laws
| STATE | RATE |
|---|---|
Iowa
| 0% to 15%
|
Kentucky
| 0% to 16%
|
Nebraska
| 1% to 18%
|
New Jersey
| 0% to 16%
|
Pennsylvania
| 0% to 15%
|
State inheritance and estate tax
| STATE | ESTATE | INHERITANCE |
|---|---|---|
Maryland
| $5 million (0.8% to 16%)
| 0% to 10%
|
How to help your beneficiaries avoid taxes on life insurance
Here are a few tips to help maximize the death benefit payout to your beneficiaries by avoiding taxes.
Planning ahead for the death benefit
- Advise your beneficiaries to accept the death benefit payout as a lump sum. This way, they will avoid potential taxes on installment payouts due to the interest that’s paid.
- Avoid naming the beneficiary as “payable to my estate.” This will make it less likely that your policy will become part of your estate, potentially triggering estate taxes.
- Add a contingent beneficiary to your policy to avoid having the death benefit transferred to your estate if the primary beneficiary dies before receiving the death benefit.
- Look into naming the beneficiary as an “irrevocable life insurance trust” to separate any cash value from your estate.
Blueprint is an independent publisher and comparison service, not an investment advisor. The information provided is for educational purposes only and we encourage you to seek personalized advice from qualified professionals regarding specific financial decisions. Past performance is not indicative of future results.
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