Purchasing life insurance is a decision that can provide your family with financial security if tragedy were to occur. However, similar to any other financial decision, there are always tax consequences to consider.
This post will explore the commonly asked question: Is life insurance taxable? We’ll also look at the tax implications from the perspective of the beneficiaries and policyholders.
Summary of Life Insurance Taxability
Before going into detail about whether life insurance is taxable, here is a brief overview of life insurance taxability.
| Scenario | Taxability |
|---|---|
| Death benefits from a term or permanent policy are paid out immediately | Not considered taxable income for the beneficiary. However, estate taxes may apply depending on the size of the estate. |
| Interest or other earnings above the original death benefit | Taxable |
| Premiums paid for life insurance | Not considered tax deducible unless they can be considered a business expense |
| Cash value that grows inside the life insurance policy | Not taxable until withdrawn |
| Cash surrender value from a canceled policy | Taxable on the portion that represents cash value earnings |
| Loans against the cash value | Not taxable |
Are life insurance proceeds taxable?
The short answer is no. The benefits beneficiaries receive (AKA, life insurance proceeds) are not considered gross income and are therefore not taxable. However, there are instances when you will need to pay taxes on parts of a life insurance benefit.
When are death benefits taxable to the beneficiary?
A common situation where life insurance proceeds may be taxable is if the death benefit earns any interest or investment distributions (such as capital gains and dividends). The IRS deems any payment above and beyond the original death benefit as taxable income.
For example, suppose a beneficiary decides to delay receiving some (or all) of the life insurance proceeds for a few months. These proceeds will likely earn interest. Once the insurance company pays out the death benefit, the beneficiary will be liable for paying tax on the accrued interest.
Alternatively, insurers may offer to annuitize or spread payments over five or more years. During this time, the held benefit earns a fixed interest rate. If the beneficiary opts to be paid in installments, they will be liable for taxes on any interest earned.
When else are life insurance proceeds taxable?
As previously stated, death benefits are generally not reported as income, so beneficiaries don’t pay taxes on death benefits unless it has earned interest. However, there are other instances where the IRS will expect a tax payment.
While beneficiaries may avoid income taxes, estate taxes may still apply. When the insured passes away, the IRS can charge taxes against the value of their estate. Ultimately, the life insurance policies (even those paid out to beneficiaries) will be counted as part of the estate.
As of 2022, the federal estate tax exemption limit is $12.06 million for single filers and $24.12 million for joint filers. The only exception is if the policyholder leaves the death benefit to their spouse. It is also important to note that each state has its own estate tax requirements.
If you are an individual with a high net worth, look into an ILIT (irrevocable life insurance trust). ILITs allow the disbursements from life insurance companies to be paid without triggering estate taxes. ILITs are considered separate entities from their policyholders, meaning they are not part of the policyholder’s estate.
What are the tax implications of life insurance while you’re living?
Now that we know how life insurance works for your beneficiaries, what about you – the insured? Do you have to pay taxes? Do you get any tax breaks for managing and paying into your life insurance policy? Let’s dig into a few scenarios.
Are life insurance premiums tax deductible?
Because you’re doing something financially responsible, you may wonder: Is life insurance tax deductible? The answer, unfortunately, is no. The IRS considers purchasing life insurance to be a personal expense. Therefore, it is a nondeductible expense.
However, there is one exception if you’re a business owner – your life insurance premiums can be considered a business expense (i.e. purchasing group life insurance for your employees). While this exception seems straightforward, you should consult a tax professional before claiming the deduction on your tax form.
Is the cash value of life insurance taxable?
Your policy’s cash value is “tax-deferred,” meaning the money will not be taxed as long as it grows inside the policy. The concept is similar to a traditional 401k or IRA in that you can always borrow or take out cash without tax consequences. If you ever decide to withdraw your funds, you must report gains on your federal income tax return and pay taxes.
Is the cash surrender value of life insurance taxable?
If you decide you no longer want or need your permanent life insurance policy, you’ll receive your remaining cash value (minus applicable fees). Insurance companies call this your “surrender cash value.” Because you paid your premiums with money that was already taxed (i.e. your income), the cash surrender value is considered the return of your premiums. That means you will only owe taxes on the amount you receive minus the total premium payments you’ve made.
For example, if you’ve paid $20,000 in premiums, and the cash surrender value is $22,000, only $2,000 of the cash surrender value is considered taxable income.
Are loans against cash value taxable?
When you borrow money from the bank or use your credit card, you don’t have to pay taxes on that money. In the same way, loans taken against the cash value of permanent life insurance policies are not taxable. This creates a unique opportunity for policyholders to access the cash value of their insurance policy without reducing their death benefit or facing additional taxes.
There is one caveat to this, however. If the policy defaults or is canceled with an outstanding loan, then the loan becomes part of the cash surrender value. In this case, the same tax rules as above will apply.
Let Us Help You Find the Right Life Insurance Product
Life insurance can feel complicated, especially when you weigh tax implications, but the experienced life insurance advisors at Principled Life are here to help you make sense of it all.
If you have any questions about which life insurance products might be right for you and how they might affect your tax situation, please feel free to give us a call. We believe there’s a plan for every budget and every condition, and we want to help you find the right policy fit for your life.
