Is Life Insurance Taxable?

If you’re considering a life insurance policy, chances are you have a lot of questions. That’s not uncommon, and it’s why we’ve created a guide detailing life insurance for beginners. But one major question people have is whether or not life insurance is taxable. In this in-depth guide, we provide the answers and some tips for minimizing or avoiding life insurance taxes.

First let’s cover some basics. Life insurance coverage is a contract between a policy owner and a life insurance company. The contract provides financial protection to named beneficiaries of the policyholder. In exchange, the policy owner agrees to make regular payments — called premiums — towards the policy. However, what happens with that policy before and after death can have significant tax implications.

Keep reading for an analysis of how life insurance can be taxed, and ways you can reduce or avoid those taxes.

Are life insurance proceeds taxable?

Generally, life insurance proceeds are not taxable. As a beneficiary, if you receive a life insurance payout following the death of the insured person, you’re not required to include the proceeds in your gross income. This means that when it’s time to file your taxes, you don’t have to report it as taxable income. That said, any interest you earn from life insurance proceeds is taxable and must be reported as interest received.

If you received the life insurance policy in a transfer-for-value deal — meaning that it was transferred to you in exchange for cash or something else of value — then the tax exclusion is limited to the total sum of your consideration; that is, the total amount you spent to purchase and sustain the policy. This amount includes your consideration, additional premium payments and certain other amounts paid. Any amount above that is taxable and the tax liability falls on you as the new policy owner.

How is life insurance taxed?

Life insurance is taxed depending on whether it’s a death benefit, cash value, part of an estate or an employer group policy. The following is a breakdown of how life insurance can be taxed in each of those instances.

Death benefit taxation

Life insurance benefits that you receive after the death of the insured person (i.e., death benefits) aren’t taxable unless the insured obtained the policy in a transfer-for-value transaction, as previously described. However, interest from the policy is taxable. If you receive the death benefit as a lump sum, you’ll only report the amount of interest the policy has earned from the time the insured person died to when you cash out the policy. Since it's a lump sum payment, you're only required to report the interest earned once.

In the event that you receive a life insurance death benefit in installments, the principal amount will be tax-free, but any interest earned on it will be taxable. To calculate the tax-free portion, take the full payout due to you at the time of the insured’s death (that is, the lump sum amount payable at the death of the insured) and divide it by the number of planned installments. Any amount above that figure is taxable interest that you must report to the IRS.

One exception to this is if the insured person was your spouse and died before October 23, 1986, and you receive the death benefit in installments. In that case, you won’t have to claim all of the interest as income. Rather, you can exclude up to $1,000 of interest earned on the benefit each year. This is true even if you remarry.

Finally, if the life insurance policy has an accelerated death benefit rider — which allows the insured to use a part of the benefit for medical expenses related to terminal illness before death — taxes aren’t required to be paid on those disbursements. Keep in mind that accelerated death benefit riders usually reduce the amount payable to beneficiaries at the time of the insured’s death.

Cash value taxation

A cash value life insurance policy has a built-in investment feature that can accumulate funds and earn interest over time. This type of policy also allows you to borrow against the cash value in the form of a life insurance loan. As a policy owner, you can choose to surrender the policy (i.e., withdraw cash permanently). Any proceeds beyond your investment in the policy are taxable as income and need to be reported.

Your investment is the sum of all the premiums you’ve paid towards the policy minus refunded premiums, dividends, rebates and unpaid loans that weren’t reported in your income. Subtract this value from the total cash value payout and you’ll get the taxable amount.

Be sure to obtain IRS Form 1099-R, which shows the total payout and taxable parts of your cash value policy. Report the values in Form 1040 or 1040-SR on lines 5a and 5b.

Life insurance and estate taxes

If you plan to have your life insurance policy transferred to your estate after your death, the proceeds are taxed if they exceed the federal estate tax threshold set by the IRS. For 2023, this threshold is set at $12.92 million for individuals. That means any amount above that threshold is taxable. If the amount falls below that threshold, the beneficiary estate won’t be required to file estate taxes.

The taxability of life insurance premiums for business owners

If you’re an employer who owns a group life insurance policy, then the Internal Revenue Code (IRC) section 79 allows you to exclude the first $50,000 of the group policy from tax. For amounts above $50,000, your employer-paid premiums for the policy are subject to Medicare and Social Security taxes, and you — as the employer — must report them in the employee's gross income using Form W2.

Concerning the proceeds of an employer-owned life insurance policy, income earned by the beneficiary of the policy is taxable, and you — as the employer — are responsible for the tax. However, the premium payments and other contributions made towards the policy are excluded from taxation. This rule applies if you’re a business owner with a life insurance policy on the life of your employee, and you or someone related to you is a beneficiary under the life insurance contract.

The IRS allows you to exclude the full amount of proceeds from being taxed if you meet the following conditions:

• You gave a written notice to the employee before taking the life insurance policy on the employee’s life. The notice must notify the employee of your intention to do so and the employee must provide written consent to be insured.

And:

• The employee worked for you within the 12 months before death or the employee was a director or a highly compensated worker.

Or:

• The death benefit goes to the family or chosen beneficiary of the employee.

How do I avoid tax on life insurance proceeds?

The biggest benefit of a life insurance policy is that it can accumulate a large sum of money that’s transferable and tax-free to your chosen beneficiaries in the event of your death. However, without proper planning, some of those proceeds may still be included in your estate, which may be subjected to tax.

To avoid or minimize taxes on life insurance proceeds, you can do one of three things: (1) designate beneficiaries wisely, (2) create an irrevocable life insurance trust or (3) gift the policy. The following section details each.

Designate beneficiaries wisely

Section 2042 of the IRC requires the proceeds of your life insurance policy to be included in your gross estate for tax purposes if:

• The proceeds of the policy are payable directly or indirectly to your estate.

• You possessed incidents of ownership — rights over or benefits from properties — in the policy at the time of your death.

Simply put, designating your estate as a beneficiary of a life insurance policy can subject the proceeds to tax because they’ll be included in the calculation of estate taxes. This happens if the benefit pushes the estate's value beyond the IRS's estate tax threshold, which again is $12.92 million in 2023. The higher the benefit, the more likely the estate’s value is to reach the threshold.

Naming a real person as the beneficiary solves this problem because the proceeds won’t be subjected to income taxes — only the interest earned on the policy will be. Additionally, having someone else as a beneficiary removes your incidents of ownership from the policy, which also keeps the policy from being included in your estate.

Consider creating an irrevocable life insurance trust (ILIT)

Another way to separate life insurance proceeds from your estate — and thus avoid having them taxed — is to create an ILIT. This is an irrevocable trust that establishes you as the grantor, which is not considered the owner.

You can make contributions to an ILIT in the form of insurance premiums, but since you’re not considered the owner, the proceeds can’t be included in your estate. Compared to simply transferring the policy to someone else, an ILIT is a great option if you still want to have some control over the life insurance policy. It allows you to continue paying premiums without owning the policy directly or indirectly.

However, there’s one important consideration to make when contemplating whether or not an ILIT is the right fit for you. As its name suggests, the trust is irrevocable, meaning once it’s established, the insured cannot change or undue the trust after its creation.

Gift the life insurance policy

When an existing life insurance policy is gifted, the recipient typically is able to receive the death benefit tax-free. This is usually done either naming a beneficiary or transferring ownership of the policy. With the former, the original policyholder remains the owner and retains control. However, with the latter, the recipient takes ownership and the original policyholder forfeits the right to make policy or beneficiary changes.

Additionally, a new life insurance policy can be gifted, which is commonly done in cases involving children, grandchildren, young relatives or those unable to procure life insurance themselves. Since the policy is for another person, it requires obtaining their consent before the policy can officially be purchased.

Summary of Money's is life insurance taxable

Taking out a life insurance policy with a death benefit is a great way to ensure your beneficiaries are financially protected when you die. Beneficiaries pay taxes on interest, but not on the original proceeds of a life insurance policy. However, if life insurance proceeds are included in your gross estate and contribute to the estate exceeding the IRS-established threshold for beneficiaries, those proceeds may be taxed alongside your other assets. Ultimately, this can result in a life insurance inheritance tax.

There are three main ways to avoid or minimize tax on life insurance disbursements. The first is by designating appropriate beneficiaries. Secondly, consider creating an ILIT to separate the policy’s proceeds from your estate. Finally, you can gift the life insurance policy. The best life insurance companies will explain these options in greater detail to help you structure your policy in a way that lets you avoid or minimize tax impacts.