Do You Pay Taxes on Life Insurance Policies?

Life insurance is a financial tool providing security to beneficiaries upon the insured’s passing. It protects families and businesses by helping meet financial obligations. While often tax-free, the tax treatment of life insurance is nuanced, with specific situations and policy features determining whether taxes apply. Understanding these intricacies is important for financial planning, as implications extend beyond the death benefit to cash value growth, withdrawals, and estate considerations.

Taxation of Death Benefits

Life insurance death benefits paid to a beneficiary are not taxable income for federal income tax purposes. The lump sum amount received by a beneficiary upon the insured’s death passes to them tax-free. This tax-free treatment is a significant advantage of life insurance.

Exceptions exist where a portion or all of the death benefit becomes taxable. One such exception is the “transfer for value” rule. If a life insurance policy is transferred from one owner to another for valuable consideration, the death benefit may become partially or fully taxable to the recipient. The taxable amount is the death benefit minus the consideration paid for the policy and any subsequent premiums paid by the new policy owner. This rule aims to prevent policies from being used as investment vehicles. Exceptions include transfers to the insured, a partner of the insured, or a corporation where the insured is an officer or shareholder, which can allow the death benefit to remain tax-free.

Interest on retained proceeds is taxable. If beneficiaries opt to leave the death benefit with the insurance company to earn interest rather than receiving a lump sum, any interest earned is taxable income. While the death benefit remains income tax-free, the accrued interest is subject to income tax.

Employer-owned life insurance (EOLI) has tax implications for employers. Death benefits from EOLI policies are tax-free to the employer if notice and consent procedures were followed when the policy was issued. If these requirements are not met, the death benefit received by the employer may be taxable to the extent it exceeds the premiums and other amounts paid. Employers must file an annual information return, Form 8925, for EOLI arrangements.

IRS Form 712 reports life insurance policy value for estate tax purposes. It details the policy’s face amount, any outstanding loans, and accumulated dividends to assess its value for estate tax calculations. It is filed by the executor of an estate, typically with Form 706, but it does not determine the income taxability of the death benefit itself.

Taxation of Living Benefits

Many permanent life insurance policies include a cash value component that grows over time. This growth is tax-deferred, meaning earnings are not taxed while held within the policy. This allows the cash value to compound without annual taxation. The cash value is a living benefit, accessible to the policyholder during their lifetime.

When accessing the cash value, understanding the policy’s “cost basis” is important. The cost basis represents the total amount of premiums paid into the policy, less any prior untaxed withdrawals. This amount is considered a return of principal and can be withdrawn tax-free. Only amounts received in excess of the cost basis are subject to income tax.

Withdrawals from a permanent life insurance policy’s cash value are taxed on a “first-in, first-out” (FIFO) basis. Withdrawals are first considered premiums paid (the cost basis), which are tax-free. Then, accumulated earnings are taxable as ordinary income. Policyholders can withdraw up to their cost basis tax-free. If the withdrawal exceeds the cost basis, the excess amount, representing the gain, becomes taxable.

Policy loans are another way to access the cash value and are not taxable income. Loans are treated as debt against the policy’s cash value, not as earnings withdrawals. The cash value serves as collateral. If a policy lapses or is surrendered with an outstanding loan, the untaxed loan amount may become taxable as ordinary income. This occurs because the loan is no longer secured by a valid policy, and the amount previously borrowed is then treated as a distribution.

Other Tax Considerations for Life Insurance Policies

When a life insurance policy is surrendered, any amount received that exceeds the cost basis is subject to ordinary income tax. No tax is owed if the cash surrender value is less than the total premiums paid. This gain is taxed as it represents accumulated tax-deferred earnings.

Dividends from participating life insurance policies are treated as a return of premium and are not taxable up to the cost basis. If the dividends, when combined with other withdrawals, exceed the total premiums paid, the excess amount becomes taxable as ordinary income. Interest earned on accumulated dividends is taxable income.

Life insurance premiums paid for personal policies are not tax-deductible. This applies to most individual policies. Limited exceptions for businesses exist, but generally do not apply to the average individual policyholder.

A “1035 exchange” allows for the tax-free transfer of cash value from one life insurance policy to another, or from a life insurance policy to an annuity, or vice versa, under IRS rules. This allows policyholders to exchange an existing policy for a new one without triggering a taxable event on accumulated gains. It allows individuals to adjust contracts to suit changing financial needs without immediate tax liability on cash value growth.

Life Insurance and Estate Planning

Life insurance proceeds can be included in the deceased’s gross estate for federal estate tax purposes. Inclusion occurs if the insured retained “incidents of ownership” in the policy at the time of their death. These rights include changing beneficiaries, borrowing against cash value, surrendering or canceling the policy, or assigning it to another party. If these rights are held, the death benefit is considered part of the estate and could be subject to estate taxes if the total estate value exceeds the federal estate tax exemption threshold.

To exclude life insurance proceeds from the taxable estate, a common strategy involves transferring ownership of the policy to an Irrevocable Life Insurance Trust (ILIT). An ILIT is a legal arrangement that owns the life insurance policy, removing the proceeds from the insured’s direct ownership and taxable estate. When the insured dies, the death benefit is paid to the ILIT, which then distributes funds to beneficiaries according to the trust’s terms, bypassing the estate tax process. This strategy helps preserve the full death benefit for heirs, especially for individuals with large estates.

Transferring a life insurance policy to an ILIT or making premium payments has gift tax implications. The transfer of the policy or premium payments is considered a gift to the trust beneficiaries. Depending on the value of the gift and the annual gift tax exclusion, these transfers may require the filing of a gift tax return, Form 709. However, proper planning, such as utilizing the annual gift tax exclusion or Crummey powers within the trust, can manage these implications.

Federal estate taxes apply only to very large estates due to a substantial federal estate tax exemption amount that changes periodically. Most estates do not owe federal estate tax. However, for estates exceeding this threshold, life insurance proceeds, if included in the gross estate due to incidents of ownership, can contribute to the overall estate tax liability.