Do You Have to Pay Taxes on Life Insurance Money?

Life insurance provides a sum of money to designated beneficiaries upon the insured’s death, offering financial security to help loved ones manage expenses or maintain their lifestyle. Life insurance death benefits are generally not subject to income tax for the beneficiary.

Understanding Death Benefit Taxation

The principal amount of a life insurance death benefit paid as a lump sum to a beneficiary is exempt from federal income tax. Beneficiaries receive the full face value of the policy, and the Internal Revenue Service (IRS) does not require these proceeds to be reported as gross income.

However, if a beneficiary chooses to receive the death benefit in installments rather than a single lump sum, any interest earned on the unpaid balance becomes taxable. This interest is considered ordinary income and must be reported by the recipient. For instance, if a $500,000 benefit accrues $50,000 in interest over time, that $50,000 would be subject to income tax.

The “transfer-for-value” rule can trigger taxation on a death benefit. This rule applies when a life insurance policy, or an interest in it, is transferred for valuable consideration. The death benefit may become partially or fully taxable to the transferee, specifically the amount exceeding the consideration paid and any subsequent premiums. Exceptions exist for transfers to the insured, a partner of the insured, or a corporation where the insured is an officer or shareholder, allowing the death benefit to remain tax-free.

Death benefits may be subject to estate tax if the policy is included in the deceased’s taxable estate. This occurs if the estate is named as the beneficiary or if the policyholder retained “incidents of ownership” over the policy, such as the right to change beneficiaries or borrow against the cash value. For 2024, the federal estate tax exemption is substantial, meaning only very large estates face this tax. Some states may also impose estate or inheritance taxes, depending on the estate’s value and state laws.

Tax Implications of Cash Value

Permanent life insurance policies, such as whole life or universal life, accumulate a cash value component over time, which grows on a tax-deferred basis. This means policyholders do not pay taxes on the growth as it occurs within the policy. Accessing this cash value during the insured’s lifetime can have various tax consequences depending on the method used.

When withdrawing from a policy’s cash value, amounts up to the policyholder’s “basis” (generally the total premiums paid) are considered a return of principal and are tax-free. However, any withdrawals exceeding this basis are taxed as ordinary income. Withdrawals can also reduce the policy’s death benefit and may lead to surrender charges if taken early in the policy’s life.

Surrendering a life insurance policy means terminating the contract for its cash surrender value. If the amount received upon surrender is greater than the total premiums paid, the gain is taxable as ordinary income. This taxable amount is the difference between the cash value received and the policyholder’s basis.

Policy loans taken against the cash value are tax-free, as they are considered debt rather than withdrawals of earnings. The cash value serves as collateral, and the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the untaxed portion of the loan amount (specifically any gain) may become taxable as ordinary income. Interest accrues on policy loans, and if not repaid, it can reduce the death benefit.

Selling a life insurance policy to a third party, known as a life settlement, has tax implications. For terminally ill individuals with a life expectancy of 24 months or less, proceeds from a viatical settlement are tax-exempt, treated as an accelerated death benefit. For non-terminally ill individuals, life settlement proceeds are taxed in tiers: the amount up to the policy’s basis is tax-free, the amount exceeding the basis up to the cash surrender value is taxed as ordinary income, and any amount above the cash surrender value is taxed as a capital gain.

Taxation of Other Life Insurance Payouts

Policy dividends, which are distributions from a mutual insurance company’s surplus, are not considered taxable income up to the amount of premiums paid. The IRS views these as a return of unused premiums. However, if cumulative dividends exceed the total premiums paid, the excess becomes taxable as ordinary income. Any interest earned on dividends left with the insurer is also taxable income.

Accelerated death benefits allow a policyholder to access a portion of their life insurance death benefit while still alive, due to a terminal or chronic illness. These payments are excluded from gross income and are tax-free. To qualify, specific criteria must be met, such as a physician’s certification of terminal illness with a life expectancy of 24 months or less. For chronically ill individuals, tax-free status may depend on funds being used for qualified long-term care expenses.

A 1035 exchange permits the tax-free transfer of funds from one life insurance policy to another, or to an annuity, without triggering immediate tax consequences on any gains. This provision, under Internal Revenue Code Section 1035, allows policyholders to switch to a more suitable contract while preserving the tax-deferred status of their accumulated value. To qualify, the exchange must be a direct transfer between insurance companies, and the policyholder must remain the same. Cashing out an old policy and then buying a new one would not qualify and would result in taxable gains.