Is Life Insurance Taxable in NY? Federal & State Rules

Life insurance policies provide financial security for beneficiaries. Understanding the tax implications can be complex, as treatment varies by policy type, access method, and federal and state regulations. This article clarifies the tax landscape, focusing on federal guidelines and New York State specifics.

Federal Income Tax on Life Insurance Death Benefits

Life insurance death benefits are generally received free from federal income tax by the beneficiary. This applies when proceeds are paid in a lump sum directly to the designated beneficiary. This tax-exempt status is a fundamental aspect of life insurance, codified under Internal Revenue Code Section 101, ensuring financial support reaches beneficiaries without income tax diminution.

There are specific situations where death benefits may become partially or fully taxable. The “transfer for value” rule applies if a policy is transferred for valuable consideration, making the death benefit taxable to the extent it exceeds the consideration paid and subsequent premiums. Exceptions exist for transfers to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer.

Beneficiaries electing installment payments rather than a lump sum may face taxation on interest earned. While the original death benefit remains income tax-free, any interest on delayed payments is subject to federal income tax. For example, a $500,000 death benefit accruing $50,000 in interest would result in the beneficiary owing income tax on that $50,000.

Federal Income Tax on Life Insurance Cash Value and Loans

Permanent life insurance policies feature a cash value component that grows on a tax-deferred basis. The annual increase in a policy’s cash value is not subject to income tax as it accumulates, allowing for potentially more rapid growth compared to annually taxed investments.

When accessing the cash value through withdrawals, the “cost basis” of the policy is a significant factor. The cost basis represents the total premiums paid, less any prior tax-free distributions. Withdrawals are generally treated under the “first-in, first-out” (FIFO) rule, meaning amounts are considered a return of premiums (cost basis) first, and are tax-free up to that amount. Only withdrawals exceeding total premiums paid become taxable as ordinary income.

Policy loans generally provide tax-free access to the cash value as long as the policy remains in force, as the Internal Revenue Service views them as loans, not withdrawals. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the policy’s cost basis can become taxable as ordinary income, treated as a distribution.

Surrendering a permanent life insurance policy means terminating the contract for its cash surrender value. The difference between the cash surrender value received and the policy’s cost basis is a taxable gain, taxed as ordinary income at the policyholder’s rate. If the cash surrender value is less than or equal to premiums paid, there is typically no taxable gain.

Federal Income Tax on Life Insurance Dividends and Policy Sales

Dividends paid by participating life insurance policies are generally considered a return of premiums and are not taxable until cumulative dividends exceed total premiums paid. If dividends exceed total premiums paid, the excess is taxable income.

Policyholders can use dividends in several ways, with varying tax implications. Dividends taken as cash, used to reduce future premiums, or applied to repay a policy loan are generally non-taxable if they do not exceed the cost basis. Interest earned on accumulated dividends left with the insurer is taxable.

Selling a life insurance policy, such as through a life settlement or viatical settlement, has specific tax rules. In a life settlement, the amount received above the policy’s cost basis is generally taxable. The gain may be taxed as ordinary income up to the cash surrender value, with any excess potentially taxed as capital gains. Viatical settlements, involving the sale by a terminally or chronically ill individual, may receive more favorable tax treatment, with proceeds often tax-exempt.

New York State Tax Rules on Life Insurance

New York State generally conforms to federal income tax rules for life insurance policies. If an amount is not subject to federal income tax, it is typically not subject to New York State income tax. Conversely, if an amount is federally taxable, it will usually be taxable for New York State income tax.

New York State has its own distinct estate tax, which can apply to life insurance proceeds even if income tax-free. Proceeds may be included in the deceased’s taxable estate for New York estate tax purposes, particularly if the deceased owned the policy at death. The New York State estate tax exemption for deaths on or after January 1, 2025, is $7.16 million, considerably lower than the federal exemption of $13.99 million per person for 2025.

A unique feature of the New York estate tax is its “cliff” or “bubble” effect. If an estate’s value exceeds the New York State exemption by more than 5%, the entire estate becomes subject to the state estate tax from the first dollar. For example, in 2025, an estate exceeding approximately $7.518 million (105% of the $7.16 million exemption) is taxed on its entire value. New York State does not have a separate gift tax, but certain gifts made within three years of death may be included in the taxable estate.