Life Insurance

Is Life Insurance Taxable?



Life insurance death benefits aren’t typically taxed, which is one of the primary upsides to life insurance. Since life insurance death benefits can be in the millions of dollars, it’s a significant advantage to buying (and receiving) life insurance.

But there are other aspects to life insurance that won’t get past the taxman.

Is a Life Insurance Payout Taxable?

Life insurance death benefit payouts are usually not taxable. That means beneficiaries will receive the money without a tax burden hanging over their heads.

However, there are certain situations where a life insurance death benefit may be taxable. Here’s a look at when to prepare for a tax bill.

You are a life insurance beneficiary who receives interest on a death benefit

Most life insurance payouts are made in one lump sum right after the death of the insured person. But if a beneficiary chooses to delay the payout or take the payout in installments, interest may accrue. In that case, the interest paid to the beneficiary may be taxed.

The life insurance payout goes into a taxable estate

Most life insurance payouts are made tax-free directly to life insurance beneficiaries. But if a beneficiary was not named, or is already deceased, where does the life insurance death benefit go? It goes into the estate of the insured person and can be taxable along with the rest of the estate.

This could create a significant tax bill, especially considering both federal and state estate taxes may be applied. While federal estate taxes will not tax the first $12.06 million per individual as of 2022, state estate taxes can have significantly lower exemption levels.

Another possible unhappy scenario is that an estate is below the exemption level but a large life insurance payout to the estate pushes it above the exemption threshold into taxable territory.

This is avoidable by naming both primary and contingent life insurance beneficiaries and keeping those selections up to date.

The life insurance policy involves three different people

Life insurance death benefits can become a taxable gift in a situation where three people serve three different roles in connection with the life insurance policy. The positions include:

  • The policyowner. This is the person who purchased the policy and is ultimately responsible for paying the premiums.
  • The insured. This person’s life is covered by the life insurance policy.
  • The beneficiary. This person receives the death benefit when the insured person dies.

For example, say a husband purchases a life insurance policy for his wife, and their son will be paid the death benefit. Suppose the wife (the insured) dies and the son (the beneficiary) receives the death benefit. In that case, the IRS considers the life insurance payout a gift from the husband (the policyowner) to the son. This is sometimes referred to as the “Goodman triangle” or “Goodman rule,” named after a decades-old court case regarding this issue (Goodman v. Commissioner of the IRS).

If this triangle exists, the policyowner may have to pay gift tax for the life insurance payout that exceeds federal gift tax exemption limits. In 2022, the annual gift exclusion is $16,000 per individual and the lifetime limit (known as a basic exclusion) is $12.06 million per individual.

To avoid tax implications from the Goodman triangle, limit insurance policy involvement to only two people: a policyholder who is also the insured and the beneficiary. A remedy to the example above is for the wife to be the policyowner and insured, maintaining the son as the beneficiary.

Is the Cash Value in a Life Insurance Policy Taxable?

If you have a cash value life insurance policy, you can generally access the money through a withdrawal, a loan or by surrendering the policy and ending it.

One of the reasons to buy cash value life insurance is to have access to the money that builds up within the policy. When you pay premiums, the payments generally go to three places: cash value, the cost to insure you and policy fees and charges. Money within the cash value account grows tax-free, based on the interest or investment gains it earns (depending on the policy). But once you withdraw the money, you could face a tax bill.

Money that’s withdrawn from cash value is generally made up of two parts:

Types of money Taxable?
Money that came from your premium payments This component of a withdrawal isn’t taxable. In the life insurance industry, this part is called the “policy basis.”
Money that came from interest or investment gains This portion is subject to income taxes if you withdraw it. Your life insurance company will be able to tell you what amount in a withdrawal is “above basis” and taxable.

If your life insurance policy is a “modified endowment contract,” or MEC, different tax rules apply and it’s best to consult a financial professional to understand tax implications.

Here are situations where cash value may be taxable.

You surrender the life insurance policy

There can be times when a policyowner no longer wants or needs the life insurance policy. You can take the surrender value of the life insurance policy and the insurer will terminate the coverage. The amount you receive is your cash value minus any surrender charge. You can generally expect to get a surrender charge within the first 10 or 20 years of owning the policy, and over time the surrender charge phases out.

You won’t be taxed on the entire surrender value, though. You’ll be taxed on the amount you received minus the policy basis, or the total premium payment you made on the policy. This taxable amount reflects the investment gains that you took out.

Say the premiums you’ve paid over many years add up to $38,000 and your total cash value is $45,000. The portion of the payout that would be taxed is $7,000, representing the investment gains.

You took out a policy loan and the life insurance ends

If you have a life insurance policy with cash value and take out a loan against it, the loan isn’t taxable—as long as the policy is in force. But if the policy terminates before you’ve paid the loan back, you could get a tax bill. For example, the coverage terminates if you surrender the policy or it lapses.

The taxable amount is based on the amount of the loan that exceeds your policy basis. Policy basis is the portion you’ve paid in premiums. Amounts “above basis” are based on interest or investment gains on cash value.

One way to access all your cash value and avoid taxes is to withdraw the amount that’s your policy basis—this is not taxable. Then access the rest of the cash value with a loan—also not taxable.

If you die with a loan against the policy, the death benefit is reduced by the outstanding loan amount.

You sell the life insurance policy

There’s a market for existing life insurance policies, especially cash value life insurance policies that insure people who are terminally ill or have short life expectancies. Transactions involving terminally ill policyowners are called “viatical settlements.” These involve an investor, such as a company specializing in buying policies, paying you money for the policy, becoming the policyowner and then making the life insurance claim when you pass away.

Viatical settlements are typically used as a way for patients to get money for medical bills, especially when selling a life insurance policy will mean getting more money than simply surrendering it for the cash value.

Fortunately, the IRS doesn’t treat any portion of what you receive for a viatical settlement as taxable. Under IRS code 101(g)(2), an amount paid by a viatical settlement provider is treated like a payment of the death benefit—and death benefit payouts are not taxable.

A life settlement is a similar transaction but involves a policyowner who is not terminally ill. In these cases, the IRS does not see the proceeds as a payment of death benefit. A portion of what you receive can be taxable.


Summary: When Is Life Insurance Taxable?

Situation What part could be taxable?
You withdraw money from cash value Any amount you receive above “policy basis”
You surrender a policy for cash Any amount you receive above “policy basis”
You take a loan against the cash value None, as long as the policy remains in-force
You sell the policy through a viatical settlement None
You’re a beneficiary who receives a life insurance payout plus interest The interest amount
The life insurance payout goes into your estate Any amount of the estate that’s subject to state or federal estate taxes.
You sell your life insurance in a viatical settlement None


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