It’s only natural to want to leave something behind for loved ones after you pass on. Many people do this with a life insurance policy that pays a death benefit when the policy holder dies. However, you may wonder if your beneficiary will have to pay taxes on the death benefits they receive.
The answer is no. Life insurance proceeds are not taxable for most people. Let’s take a look at some of the taxable and non-taxable events that involve life insurance.
- Lump Sum Death Benefits Paid Out to Beneficiaries are Not Taxable
- Other Times When Life Insurance Proceeds are Not Taxable
- When are Life Insurance Proceeds Taxable?
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Lump Sum Death Benefits Paid Out to Beneficiaries are Not Taxable
The most common reason for people to get life insurance, especially whole life or universal life insurance, is so they can give loved ones (beneficiaries) a lump sum payout, called the death benefit, after they die. According to the IRS website, life insurance proceeds aren’t considered gross income and don’t have to be reported when filing taxes. Essentially, your beneficiaries don’t have to pay taxes on the life insurance proceeds they receive.
However, there is a noble exception in the case of an investor buying a life insurance policy and receiving the death benefit as a beneficiary as we discuss the details below.
>>MORE: Tax Benefits of Life Insurance: Compare with Other Retirement and Investment Options
Other Times When Life Insurance Proceeds are Not Taxable
There are many ways your life insurance policy can gain value to benefit you or a loved one. Thankfully, most of these events are not considered taxable. Let’s take a look:
Cash-Value Portion Increases Over Time
When the cash-value portion of a whole life insurance policy or a indexed universal life insurance or variable universal life insurance policy increases over time it also increases the potential payout of your death benefits. Even though this is an increase the value of your assets, the cash-value gains to your policy aren’t taxable.
>>MORE: Understanding Indexed Universal Life Insurance: Why Is It Good for Retirement Savings?
Annual Dividend Payouts
If you have a dividend paying whole life insurance policy, you don’t have to worry about paying taxes on the dividends either. It doesn’t matter if you take the dividend as cash, use it to buy more insurance, or pay it towards your premiums. The dividend you receive isn’t taxable as long as it’s not more than the value of the policy premiums for the year.
Withdrawal or Loans from the Cash-Value Account
If you have a permanent life insurance policy with a cash value account, you can take out a part of the proceeds as withdrawal or loans. As long as your policy isn’t a Modified Endowment Contract (MEC), you are not required to pay back the money, nor will you pay taxes on it. You have to pay interests on loans, which is usually paid from the cash value account as well. The amount you loan and interest payment on the loan both come from the cash value account and will be deducted from the death benefit of the policy before they are paid to a beneficiary.
This is a significant advantage of permanent life insurance over investment accounts and the main reason why people are using life insurance policy as part of their retirement plan. Tax-free cash distributions from indexed universal or variable universal life insurance are great supplement retirement income.
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Accessing the Death Benefit Early
There are both whole life insurance and term life insurance policies with accelerated death benefit riders. It’s only possible to access the death benefit early if you have been diagnosed with a terminal or chronic illness and need a long term care. If needed, you’ll be able to take out part of the value of the death benefit and give it to yourself to pay for living expenses. This death benefit isn’t taxed even though you are using it as potential income.
Surrendering or Selling Permanent Life Insurance
Sometimes people opt to sell their permanent life insurance to an investment company or surrender it back to the insurance company. If the amount of money you get from surrendering or selling your permanent life insurance is less than the amount you’ve paid into it over the years, you won’t owe any taxes. However, you will have to pay income taxes on the difference if your cash-value is more than what you’ve paid in premiums.
For example, you have had a whole life insurance policy for 6 years. You have paid annual premium of $1,200 for 6 years, total $7,200. The cash value account is the same as surrender value of the policy and at $5,600. Sometimes these two numbers are difference if the insurance company still have surrender charge on your policy. Now you want to cancel the policy, you will receive $5,600. You don’t have income tax in this situation. However, if the surrender value is $8,500. You will have to pay income tax on the difference between $8,500 and $7,200, which is $1,300.
When are Life Insurance Proceeds Taxable?
There are a few exceptions to every rule, and as you can imagine there are a few times when life insurance proceeds do become taxable. It’s not likely the average family will have to worry about these taxable events when receiving life insurance, but it’s good to know about them.
When the Insurance Payment is Delayed
In some instances, the life insurance company may not pay the death benefits to beneficiaries right away. For example, the insurance company might have trouble tracking down the beneficiary and may not make payment to a full year. Or, you’ve directed the life insurance company to pay out the death benefits as installments over time.
Law requires the life insurance company to pay interest on any death benefits that are being held by them. The interest earnings will be taxable. However, the original cash-value of the life insurance policy is still not taxed.
>>MORE: How Much Income Tax Do You Have to Pay in Retirement? A Case Study
When Life Insurance Policy is Sold to an Investor
This is also called “Transfer-for-Value Rule”. In this case, the death benefit will be paid out to the investor who has bought the policy, become the beneficiary of the policy, and has been paying premiums for the policy. The investor will have to pay income tax on the difference between the death benefit and his total expenses on the policy. For example, an investor buys a $300,000 whole life policy for $200,000. After buying the policy, he has paid premiums for 5 years, $2,000 each year. The insured dies in the fifth year and he receives $300,000 death benefit from the insurance company. In this case, he has to pay income tax on $90,000, which is the result of ($300,000 – $200,000 – $2,000*5).
An Estate Worth More than $11.58 Million
If the value of your estate is more than the IRS exemption for estate taxes of $11.58 million (this number might change over time), and you have named beneficiaries other than a spouse, your life insurance policy may be considered part of your estate. This also includes the case of “bring-back rule”. Bring-back rule means that you have transferred your life insurance policy to someone else so that it doesn’t include in your estate. However, if you did this less than 3 years before you die, the death benefit of your life insurance policy will still be included in your estate. This could expose the life insurance policy to a few different taxes, including:
- Estate Tax: This is a federal and state tax on the estate of the deceased that is applied before the monies are distributed to beneficiaries.
- Inheritance Tax: There is no federal inheritance tax, but there are some states with an inheritance tax. This tax is charged to a person receiving an inheritance.
- Generation-Skipping Transfer Tax: This is a federal tax applied to the person receiving an inheritance if they are younger than you or not related to you. For this tax to apply, the beneficiary would have to be unrelated and 37.5 years younger or one generation removed, such as a grandchild.
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>>MORE: Is Life Insurance Premium Tax Deductible?
Final Notes:
- Life insurance proceeds are not taxable for most people when paid out as a lump sum death benefit.
- Most increases in cash-value and loans from the value of your insurance are not taxable either.
- Annual dividends from whole life insurance policies are not taxable if less than the premiums.
- Certain events are taxable, such as when interest is earned on a death benefit before payment.
- There may be additional taxes, estate taxes and inheritance taxes, on death benefits from policies owned by those with large estates.
