- The death benefit from life insurance is typically not taxable, but you could face taxes in other situations.
- Withdrawing money from the cash value of a policy could trigger income taxes.
- When a death benefit is paid out in installments rather than a lump sum, the interest earned on the benefit is taxable.
- If you transfer your policy over to someone, the gift tax could come into play.
Life insurance is meant to protect your family. After all, you want to make sure that they’ll be able to get by after you’re gone. You may wonder, however, if that smart financial move has any tax consequences.
More often than not, life insurance passes to your heirs tax-free. Still with life insurance, taxes can come into play in certain circumstances.
Here’s what you need to know about life insurance and taxes.
Is life insurance taxable?
As a general rule, a life insurance payout is tax-free. When you die, your beneficiaries won’t have to pay taxes on the death benefit they receive. However, there are situations where life insurance can trigger a tax bill, so read on to understand the exceptions.
When could life insurance be taxable?
Life insurance can be taxable in the following situations:
Withdrawals from cash-value policies
Permanent life insurance policies (e.g. whole life or universal life) typically build a cash value, which 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—pushing you into a higher tax bracket if you aren’t careful.
Another exception to the no-tax rule can happen when the beneficiary of a life insurance policy receives the death benefit in installments rather than as a lump sum. In that case, the interest earned on the death benefit while it was being paid out would be taxable. Anything you collect above and beyond the death benefit—i.e., the earned interest—would be taxable.
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.[3, 4]
Life insurance death benefits may be taxable if “there has been a transfer for value,” says Cooper. Typically, this would apply if you transfer ownership of your policy to someone who is a beneficiary.
In this case, the value of the policy could be subject to the gift tax. In any given year, you can give a certain amount to anyone without any gift tax consequences. The gift tax exemption in 2022 is $16,000.
Plus, you have a lifetime gift tax exemption, which is $12.06 million in 2022 (same as the maximum size for an estate to be exempt from estate taxes in 2022).
So if you transfer a policy worth $50,000 today, you have to report $34,000 as a gift. However, the gift tax would only be assessed if the value of your total gifts over your lifetime is more than $12.06 million. Even then, the gift tax wouldn’t have to be paid until the death of the original policyholder.
Another key thing here: If you pass a policy on to your spouse, that is typically excluded from gift and estate taxes.
Especially with a generous life insurance policy, you may want to make sure it stays out of your taxable estate. One way that can happen is if you make your policy “payable to my estate” rather than a person. Plus, when you don’t name a beneficiary, the death benefit will be paid to the owner of the policy (assuming they’re not the insured person); otherwise it will be paid to the owner's estate.
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. So 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:
Estate tax laws
|D.C.||$4 million||11.2% to 16%|
|Connecticut||$7.1 million||10.8% to 12%|
|Illinois||$4 million||0.8% to 16%|
|Maine||$5.8 million||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%|
|Washington||$2.2 million||10% to 20%|
Inheritance tax laws
|Iowa||0% to 15%|
|Kentucky||0% to 16%|
|Nebraska||1% to 18%|
|New Jersey||0% to 16%|
|Pennsylvania||0% to 15%|
|Maryland||$5 million (0.8% to 16%)||0% to 10%|
How to help your beneficiaries avoid taxes on life insurance
Life insurance is about keeping your family safe. Here are a few tips to help your beneficiaries maximize their life insurance payouts:
Planning ahead for the death benefit
Tell your beneficiaries to accept the payout as a lump sum. This way, they will avoid potential taxes on installment payouts due to the interest that’s paid.
To make it less likely that your policy will become part of your estate, potentially triggering estate taxes, avoid naming the beneficiary as “payable to my estate.”
Look into naming the beneficiary as an “irrevocable life insurance trust” to separate out the cash value (if there is any) from your estate.
Transferred life policies
Consider providing an annual gift under $16,000 to help beneficiaries pay the premiums while avoiding the gift tax.
Consult with a tax professional to see if the transfer would be subject to an inheritance tax, based on the state they live in—and if so, how much that would come to.