Is life insurance taxable?

The insurance market has always provided people with various choices when choosing a provider, and with choices come questions. For example, a popular question revolves around whether or not life insurance is taxable. 

Taxes are frustrating enough, so we want to take the guesswork out of whether or not there are taxes on life insurance. A life insurance policy offers financial stability to the named beneficiaries of the deceased in the form of a payout. Many often question whether or not that life insurance payout is taxable.

While there are differences between the types of term life insurance policies available and what you’ll receive with a whole life insurance policy, there isn’t a life insurance policy that will be taxable.

No matter the type of coverage you have, your beneficiaries will receive a payout at the time of your passing. A payout is the amount of money the named friends or family members on your policy will receive at the time of your passing. That payout is generally not taxable.

As with most situations, there are exceptions, but traditional life insurance payouts are not subject to taxation.

Are there taxes associated with a life insurance payout? 

A payout from a life insurance policy — sometimes called a death benefit — is often tax-free, with some exceptions. Since beneficiaries don’t have to claim the death benefit as a source of income, it’s tax-free in the eyes of the government. 

So, you can use a death benefit to pay bills or cover time spent out of work, and it’s separate from traditional wages. There are some exceptions, but your life insurance policy should clearly outline them. It’s a good idea to familiarize yourself with the details of your policy because of these scenarios.

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When is a life insurance payout taxable?  

There is no such thing as a life insurance payout tax because the payout isn’t a source of income. However, the following situations will make a death benefit taxable:

Your Death Benefit Gets Paid Through Installments

A payout, or death benefit, often gets paid in one lump sum, so if the amount on the policy is $10,000, the beneficiary receives the entire amount at once. Should the beneficiary choose to receive the payout over some time, it’s then referred to as an annuity.

An annuity is an amount of money paid to someone over a period, usually annually. When the insured makes this choice, the insurer will hold onto the death benefit and pay it out to the beneficiary in installments. While the original payout still won’t be taxable, the interest that accrues as it sits with the insurer will draw income tax.

Your Estate Absorbs the Death Benefit

A life insurance payout will always be off-limits to debt collectors, even if you have an estate. The payout goes to your living beneficiaries, so no one can use your death benefit to pay off any outstanding debt that might exist as part of your estate.

However, suppose your beneficiaries are no longer alive when the death benefit gets paid out. In that case, the death benefit becomes part of your estate along with everything else, meaning that debt collectors can access that money.

This scenario also depends on the net worth of your estate. Estate taxes vary depending on the state. According to the IRS, estate taxes have seen some changes, including the limits on federal estate tax exemption.

More Than Two People Are Involved

Typically, a death benefit is only between two people. The first person is both the one being insured and is also the owner of the policy. The second is the listed beneficiary.

There are examples where there may be three people involved. For example, if a different person buys a life insurance policy for the insured, and the beneficiary is separate, the IRS will consider the death benefit a gift.

So if the insured person, the person who buys the policy, and the beneficiary are all different, a gift tax will be associated with the death benefit.

How should a life insurance payout be used? 

The advantage of a life insurance payout comes from the fact that beneficiaries can use the money as needed. This means that unlike a mortgage life insurance policy, which can only be used against a property’s mortgage, the death benefit can go towards any of the following:

• Pay off any monthly bills that come due and were paid for by the deceased
• Cover missed work during the grieving period
• Pay for the funeral if there aren’t other arrangements
• Put it into a savings account for school or college
• Long-term means such as retirement or a vacation

You can even use a death benefit to give money to charity. There are no limitations on using a payout from the deceased’s life insurance policy. 

What is cash value in terms of insurance? 

Cash value in life insurance is the part of your policy that accrues interest. Depending on the type of policy you have, you may be able to withdraw or borrow from this portion.

You may also hear cash value referred to as a living benefit for the policyholder. Many policyholders will utilize the cash value as a savings account, while others may use that money to pay for emergencies.

It’s important to note that cash value doesn’t go to your beneficiaries since it’s separate from the death benefit. If any cash value remains after your passing, that money stays with the insurer. 

Cash value is slow to accrue growth, which might be why many people don’t recommend a life insurance policy with a cash value. 

However, many choices are still available, with cash value changing depending on the type of life insurance policy you purchase. For example, whole life insurance cash value will generally grow at a fixed rate that the insurance company sets. On the other hand, term life insurance won’t render any cash value.

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Is the cash value of a life insurance policy taxable? 

Previously, we discussed scenarios where a death benefit could become taxable. There are also some situations where the cash value of a life insurance policy could have taxes levied. 

It’s important to know when and why cash value becomes taxable to avoid unwanted surprises. Below are situations where your cash value could become taxable: 

• If you surrender your life insurance policy. Canceling your coverage could make your cash value taxable. The taxable amount is the cash value above the policy amount, called the policy basis. For example, if you surrender your $20,000 life insurance policy, and the policy basis is only $10,000, the IRS will consider the other $10,000 taxable.
• If you sell your life insurance policy. If you sell your life insurance policy to a third party, you may have more money than if you surrendered it, but it still becomes taxable.
• If you take out a loan against your cash value. As mentioned above, cash value isn’t typically taxed, and taking out a loan won’t be enough for taxes to apply if you pay the loan back. If you fail to do so, you’ll have to pay the loan back and be responsible for the taxes accrued against it.

Making sure you know what the cash value is for your life insurance is half the battle. Knowing how to avoid taxes is the second half, though if you don’t plan on touching your life insurance policy for as long as you have it, you’ll be in good shape.

Case Studies: Is Life Insurance Taxable?

Case Study 1: Non-Taxable Payout for Named Beneficiaries

Sarah, a 35-year-old married individual, purchases a term life insurance policy to provide financial security for her family. She carefully names her spouse and children as the beneficiaries of the policy. In the unfortunate event of her passing, the life insurance payout will be distributed to her beneficiaries.

Since the death benefit is paid directly to the named beneficiaries and not considered income, it is generally non-taxable. Sarah’s beneficiaries will receive the full payout without any tax obligations.

Case Study 2: Taxable Payout with an Annuity Option

John, a 50-year-old individual, has a whole life insurance policy with an option to receive the death benefit as an annuity instead of a lump sum. He chooses the annuity option, which means the insurance company will hold the death benefit and pay it out to his beneficiaries in installments over time.

In this case, while the original death benefit is not taxable, any interest that accrues on the annuity payments will be subject to income tax. It’s important for John and his beneficiaries to be aware of this tax implication.

Case Study 3: Taxable Estate and Debt Collection

Emily, a 65-year-old individual, has a high net worth and a substantial estate. She owns a life insurance policy with her estate listed as the beneficiary. If Emily’s beneficiaries are no longer alive at the time of her passing, the death benefit will become part of her estate.

In this scenario, the death benefit could potentially be subject to estate taxes and used to pay off outstanding debts within the estate. It’s important for Emily to consider the tax implications of her estate and consult with professionals to ensure proper planning.

The Bottom Line

The good news is that your life insurance policy death benefit and cash value aren’t taxable. The better news is that unless you have extremely rare circumstances where you have a high-valued estate or need to surrender your policy, you likely won’t have to pay taxes against either the death benefit or the cash value.

Always double-check your policy details to know how many people are involved in your policy, how much the death benefit will be, and whether the taxability of your life insurance is affected.

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