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Is Life Insurance Taxable?
If you won a $1 million lump sum playing Powerball, Uncle Sam would immediately take $240,000 in taxes, and may even ask for up to $130,000 more come April. After the federal government is done, a lottery millionaire quickly turns into a $630 thousandaire, and that’s before your state government even takes a cut.
But say you have a $1 million life insurance policy and name your spouse or your children as the beneficiaries. If you die within the terms of your policy, your beneficiaries will receive a financial windfall of $1 million, tax free—most of the time.
Here are the ins and outs of when the death benefit might come with tax implications.
Is a life insurance payout taxable?
The death benefit (or payout, or proceeds) of a life insurance policy isn’t taxable most of the time.
However, the death benefit could be taxable in a few situations—mostly for wealthy policyholders who use the word “estate” in their inheritance planning.
Examples of when the life insurance payout might get taxed
If the death benefit is paid to an estate, and the estate is worth over $11.8 million (in 2019) including the payout, the estate tax will come down like a hammer.
Similarly, if the person who is insured is also the policyholder (the one who owns the policy), that individual’s estate could be financial fodder for the estate tax. There are a few ways around this, however:
- Name your spouse as the beneficiary. Spouses are outside the consideration of estate tax law. However, this isn’t a perfect workaround, since the spouse would have to spend all of the death benefit before they eventually pass away for the estate to avoid taxes—it’s literally a “shop till you drop” situation.
- Transfer ownership of the policy. Most people transfer ownership to a trust, which circumvents the hit a death benefit could take from the estate tax. Or, some transfer ownership to the beneficiary (typically their child), who would then receive the entire death benefit tax free. For either of these scenarios to work, the transfer must happen at least three years before the insured’s death. So, if you have a large enough estate and you own a life insurance policy that also insures you, you may want to transfer it—yesterday!
When a death benefit is paid, there are a few options on how to receive the money. For example, you could take all the money at once (lump sum) or take payment in installments. There could be financial advantages to installment payments, namely that they come with additional interest payments from the insurance company. However, any money earned in interest (but only in interest) is taxed.
Is the cash value of life insurance taxable?
Cash value is the component of a permanent life insurance policy that (ideally) accumulates interest in a tax-deferred savings account. There are a few things you can do with cash value, one of which is borrowing from it—also tax-deferred. Tax liabilities creep into cash value in just a few circumstances:
- You stop paying on your policy (you let your policy lapse) or you intentionally drop your policy (you surrender your policy). In either of these instances, if you borrowed more from your cash value than you paid in premiums, your tax liability would be the difference between the two.
- Your policy’s surrender value is higher than the money you’ve paid in premiums. If this is the case, it’s likely because your cash value investment grew—a lot. If you surrender your policy but the money you’d get back is more than what you put in, you would be taxed on the money that exceeds what you’ve paid in premiums. Keep in mind: if you surrendered your policy, the insurance company would likely receive surrender charges from you on top of the tax. It's not an ideal situation.
Is a life insurance settlement taxable?
If you decide you no longer want your life insurance policy, you can either let it lapse by no longer paying, surrender it and get whatever money you can out of it, or try to sell it and receive a life insurance settlement. In a settlement, a third party would assume your premium payments and become the beneficiary of your policy, earning the death benefit when you die. In return, they would give you money.
If you receive a life insurance settlement, the money you receive would be subject to taxes, either income tax, capital gains tax, or both, depending on your policy and how much the cash value had accumulated when you settled.
Basically, it can get complicated. So if you’re thinking of selling your policy, consider meeting with a financial advisor first.
Rarely. But when life insurance gets mixed with business, sometimes it can have tax implications. For example, if a business buys a life insurance policy for an employee, the employee owns the policy, and the business pays the premiums as a bonus, the premiums paid would be considered taxable income to the employee. There may be other tax implications with different types of business-purchased life insurance, but again, this is more the exception than the rule.
Bottom line: taxes aren’t the norm with life insurance
Except in a few, somewhat rare cases, you can feel confident that your beneficiaries will receive a completely tax-free payout in the event of your death. But of course, for that to happen, you’d have to have a life insurance policy in place first.
Not sure what kind of policy is right for you? See our Types of Life Insurance guide.
Have a policy in mind but don’t know who to buy it from? See our Best Life Insurance Companies review.