Is There Tax on a Life Insurance Payout?

Life insurance payouts provide financial support to beneficiaries upon an insured individual’s death or, in some cases, to the policy owner during the insured’s lifetime. While often perceived as tax-free, the tax treatment of these funds varies based on the payout’s circumstances and the recipient’s identity. Understanding these distinctions is important for managing financial affairs.

Taxation for Beneficiaries

When a life insurance policy pays out as a death benefit, the principal sum received by a beneficiary is exempt from federal income tax. This applies whether the beneficiary is an individual, a trust, or an estate. This tax treatment provides financial relief to those who have lost a loved one.

However, any interest earned on death benefit proceeds after the insured’s death is taxable income. This occurs if the beneficiary leaves the death benefit with the insurance company for a period instead of taking an immediate lump sum. The interest accrued on these funds is subject to ordinary income tax.

An exception to the income tax-free rule for death benefits is the “transfer-for-value” rule. This rule applies when a life insurance policy is sold or transferred for valuable consideration. If a policy is transferred for value, the death benefit may become taxable to the recipient, but only to the extent it exceeds the consideration paid for the policy plus any subsequent premiums paid by the new owner. However, 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 are exempt from this rule.

Taxation for Policy Owners

Policy owners may receive funds from a life insurance policy during the insured’s lifetime, each with distinct tax implications. Withdrawals from a policy are considered a return of premiums paid, up to the policy’s cost basis, and are tax-free. The cost basis represents the total premiums paid into the policy, reduced by any prior tax-free distributions.

Once withdrawals exceed the policy’s cost basis, the excess is taxed as ordinary income. Policy loans are not considered taxable income as long as the policy remains in force. These loans are advances against the policy’s cash value, secured by the death benefit.

If a policy with an outstanding loan lapses or is surrendered, the unpaid loan amount, up to the policy’s gain, can become taxable income to the policy owner. Dividends paid from participating life insurance policies are treated as a return of premium and are tax-free up to the policy’s cost basis. If dividends are left with the insurer to accumulate interest, that interest earned is subject to ordinary income tax.

When a policy owner surrenders a life insurance policy, any amount received exceeding the policy’s cost basis is taxable income. The cost basis for surrender is the total premiums paid, less any previously received tax-free dividends or withdrawals. Accelerated death benefits or living benefits, which allow terminally or chronically ill policyholders to access a portion of their death benefit while still alive, are received tax-free under current tax laws.

Estate Tax Implications

While life insurance proceeds are income tax-free to beneficiaries, they can be included in the deceased’s gross estate for federal estate tax purposes. This occurs if the deceased owned the policy or retained “incidents of ownership” at the time of death. Incidents of ownership refer to rights allowing the policyholder to control the policy, such as changing beneficiaries, borrowing against cash value, or surrendering the policy.

The federal estate tax applies to the transfer of property at an individual’s death. Due to the high federal estate tax exemption, only very large estates are subject to this tax. For 2025, the federal estate tax exemption for individuals is $13.99 million, meaning estates valued below this threshold do not owe federal estate tax.

Planning tools, such as an irrevocable life insurance trust (ILIT), can keep life insurance proceeds out of the taxable estate. By transferring ownership to an ILIT, the insured relinquishes all incidents of ownership, ensuring the death benefit is not included in their gross estate. This strategy benefits individuals with estates that might exceed the federal estate tax exemption.

Reporting Life Insurance Payouts

For income tax-free death benefits, insurance companies generally do not issue a Form 1099-R or other tax forms for the principal amount. Beneficiaries typically do not need to report these proceeds as income on their federal income tax returns.

However, if interest is paid on the death benefit, such as when proceeds are held by the insurer before disbursement, the beneficiary will receive a Form 1099-INT. This form reports the interest earned, which must be reported as taxable income on the beneficiary’s tax return.

For policy owner actions resulting in taxable events, such as withdrawals exceeding cost basis, policy surrenders with a gain, or loans that become taxable upon policy lapse, the insurance company will issue a Form 1099-R or a Form 1099-MISC. These forms indicate the taxable amount that must be reported on the policy owner’s federal income tax return.

If life insurance proceeds are included in a deceased’s gross estate for estate tax purposes, Form 712, Life Insurance Statement, may be required. This form provides information about the life insurance policy to the Internal Revenue Service (IRS) for estate tax valuation.