Is life insurance taxable?
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The whole point of leaving your loved ones a life insurance payout is to ensure they’re financially protected should you pass away. After all, death can be expensive. Funeral costs, settling debts and dealing with an estate cost money. Along with all the other considerations, you may find yourself asking, “are life insurance proceeds taxable?” It’s a good question. The last thing you want to worry about is leaving your loved ones with a tax liability on top of everything else.
In general, the answer is “no,” the life insurance payout is usually not taxable. And in the cases in which it is, there may be workarounds. The following article should effectively answer the question: “is life insurance payout taxable?”
Life insurance and the tax code
The U.S. tax code is the Internal Revenue Service’s (IRS) guidelines to what is (and what isn’t) taxable. The tax code covers life insurance to explain when and why life insurance may be subject to tax.
Tax code sections to know
When determining, whether or not life insurance is taxable, you’ll need to know what certain sections of the tax code have to say about death benefit payouts. As mentioned, your loved ones will receive the life insurance payout without tax implications. But there are things to watch out for:
U.S. Code, Title 26, Subtitle F, Chapter 79, § 7702
This section defines what life insurance is and whether or not payouts are taxable The details are a bit complex to understand but essentially, this section of code sets limits on how a life insurance policy works.
If you cancel a life insurance contract, the cash value of the policy can’t be more than the amount you paid to purchase it in one lump sum. Additionally, you don’t have to pay more than the insurance benefits or it’s not considered a life insurance policy.
U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter B, Part III, § 101
This section of the tax code sets guidelines on when someone may receive benefits, including the death benefit payout for beneficiaries and accelerated death benefits for the owner of the policy if he or she becomes terminally ill.
U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter L, Part I, Subpart B, § 803
This part of the code covers gross income from life insurance. It essentially explains that life insurance dividends are not taxable.
Types of taxes to know
In addition to specific applicable sections of code, knowing about certain types of taxes can reduce the chances that your beneficiary will be hit with a tax bill. These include:
Six states levy taxes on inherited property, money and assets. The tax is as high as 20%. The states that have inheritance taxes are:
- New Jersey
If the estate you leave behind has a high value, part of it may be subject to taxes. The current estate tax threshold is $11.58 million. Anything over the threshold could be taxed.
Transferring your life insurance policy to your beneficiary before you die could trigger a gift tax. The IRS uses the tax to discourage taxpayers from avoiding taxes by giving the money away. The lifetime exemption gift tax amount is the same as the current estate tax threshold of $11.58 million. The annual exemption amount is $15,000.
When is life insurance taxable?
Wondering when life insurance proceeds are taxable? Although most of the time proceeds are not taxable, you could end up triggering taxes under the following situations:
If you make a profit when you surrender your cash-value policy
If you have a permanent or whole life insurance policy and surrender it, the cash value account funds are yours. If the amount in your account has grown in value to be more than what you’ve paid in fees and premiums, the extra amount is taxable. Fortunately, the profit is usually small.
If there are several people involved
If you buy a life insurance policy on behalf of your adult nephew so his kids receive a death benefit if he passes, the child’s payout will be considered taxable income. Don’t become the owner of a life insurance policy on behalf of someone else.
If you name a trust as the life insurance beneficiary the wrong way
Naming your adult child or spouse as the beneficiary is a no-brainer. The death benefit passes straight to them tax-free. But if you choose to name a revocable family trust as the beneficiary, you complicate things if your estate is worth over $2 million. You’ll need to name an irrevocable life insurance trust as the beneficiary. Irrevocable trusts will not include life insurance payouts as part of your taxable estate.
Forgetting to name a beneficiary
If you purchase a life insurance policy, be sure you name your beneficiaries right away. If you pass away without anyone chosen to receive the death benefit, the payout passes to your estate. This could lead to tax implications if your estate is valued at over $11.58 million, the current IRS estate tax threshold.
When is life insurance not taxable?
In most situations, life insurance is not taxable. These situations are most common for those who purchase life insurance and include the following:
Naming people as your beneficiaries
Keep your death benefit tax-free by naming individuals as your beneficiaries. Your adult children, spouse, friends and/or siblings are just a few examples. You could name more than one beneficiary — just make sure to clearly state how much each beneficiary gets in the form of a lump sum amount or percentage. You could name a company, charity or trust as a beneficiary, but the payout will be subject to taxes.
When you receive dividends
If your life insurance company is a “mutual”, you own a part of the company. This means you’ll receive dividends in the form of a cash payout, based on the company’s profits, as long as you own a life insurance policy with the insurer. Dividends aren’t taxable as long as they’re not more than what you’ve paid in premiums for the year.
When you use your accelerated death benefit
Most life insurance policies come with an accelerated death benefit. This means that you can withdraw from the money you were planning on leaving for your beneficiaries to cover your expenses if you become terminally ill. You’re basically using up the death benefit for yourself. You won’t have to pay taxes on the amount you withdraw, but it reduces what your beneficiaries will receive.
Are life insurance premiums tax deductible?
Unfortunately, the premiums you pay for your life insurance are not tax deductible. The IRS considers premiums a personal expense. If you have higher income, you’ll need to look at other ways to reduce your tax liability, such as retirement planning in the form of an IRA. Or purchasing your life insurance policy through your business to write off as a business expense.
- Regardless of whether you go with term life insurance or a permanent policy, the death benefit you leave to your loved ones is not taxable. They’ll receive the full amount you paid for.
- Although life insurance isn’t taxable in most situations, it’s important to understand the tax code to steer clear of situations when you may trigger life insurance taxes.
- Life insurance premiums aren’t tax-deductible because the IRS considers them a personal expense.
- If you receive dividends on your life insurance policy, the dividends are generally not taxable.
Life insurance is an excellent way to make sure your loved ones are set up financially after you pass. Unlike other types of assets you may leave, a life insurance payout is one of the most simple and straightforward. You choose a death benefit amount, name the beneficiaries you’re leaving the payout to and pay the premiums.
In most cases, the death benefit is not taxable, and your dependents can use the payout to cover immediate expenses or to resolve outstanding debt in the event of your passing.