Is There Tax on Life Insurance Payouts?

Life insurance payouts provide financial security. While many proceeds are tax-advantaged, treatment varies by policy and how benefits are received. Understanding these nuances is important.

Death Benefits Received by Beneficiaries

When a life insurance policy pays out a death benefit to a named beneficiary, the proceeds are not subject to income tax. Beneficiaries receive the full lump-sum death benefit without reporting it to the IRS. This tax-free nature provides financial relief for needs like funeral costs, daily living expenses, or debt repayment.

However, tax treatment changes if the beneficiary receives the death benefit in installments. When payments are spread, the unpaid portion held by the insurer accrues interest. While the original death benefit is income tax-free, any interest earned on deferred payments is taxable income to the beneficiary.

For example, if a beneficiary opts for installments on a $500,000 death benefit, and the insurer pays $100,000 annually plus interest, only the interest portion is taxable. The insurance company issues a Form 1099-INT for this taxable interest income. This distinction affects tax liability and requires careful consideration of payout options.

Beneficiaries will not receive a Form 1099 from the IRS for the death benefit itself, as it is not considered gross income. This rule applies whether the policy is term life or permanent life insurance.

Situations Where Death Benefits Become Taxable

While generally income tax-free, certain situations can cause life insurance death benefits to become taxable. One scenario involves the “transfer for value” rule, outlined in U.S. tax code Section 101. This rule applies when a life insurance policy is sold or transferred for valuable consideration. If this occurs, the death benefit may become partially or fully taxable, with the taxable portion exceeding the consideration paid plus subsequent premiums by the new owner.

The transfer for value rule prevents profiting from tax-free death benefits through speculative transactions. 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. If a transfer does not meet one of these exceptions, the death benefit, beyond the investment in the contract, can be taxed as ordinary income to the recipient.

Another situation where death benefits might be taxable involves employer-owned life insurance (EOLI) policies. Businesses typically own these policies, insuring an employee’s life with the business as beneficiary. EOLI proceeds are excluded from income, but this exclusion is limited to premiums paid unless specific notice and consent requirements were met before issuance.

For the death benefit to remain income tax-free for the employer, the employee must be notified in writing of the employer’s intent to insure their life and the maximum policy amount. The employee must also provide written consent to being insured, acknowledging coverage may continue after employment and that the employer will be a beneficiary. If these conditions are not met, the death benefit exceeding premiums paid can become taxable income to the employer.

Accelerated death benefits, or living benefits, allow a policyholder to access a portion of their death benefit while still alive due to a terminal or chronic illness. These benefits are tax-free if the insured is certified as terminally ill (expected to die within 24 months) or chronically ill and funds are used for qualified long-term care expenses. However, if amounts received by a chronically ill individual exceed certain IRS per diem limits (e.g., $420 per day in 2024) and are not used for qualified long-term care, the excess could be taxable.

Taxation of Policy Withdrawals and Dividends

Beyond death benefits, accessing a life insurance policy’s cash value during the policyholder’s lifetime has tax implications. Permanent life insurance policies, like whole or universal life, accumulate cash value. Policyholders can withdraw funds, but tax treatment depends on the policy’s “cost basis.” This basis represents total premiums paid, less any prior tax-free withdrawals or dividends.

Withdrawals from the cash value are tax-free up to the policyholder’s cost basis. These amounts are considered a return of premiums already paid with after-tax dollars. However, if withdrawals exceed the cost basis, the amount above the basis is considered taxable income. This taxable portion is treated as ordinary income.

Policy loans, where the policyholder borrows against the cash value, are not considered taxable income as long as the policy remains in force. The cash value serves as collateral, and the loan is not a withdrawal of basis or earnings. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount (up to the gain) can become taxable. Interest accrues on these loans, which is not tax-deductible.

Policy dividends from participating life insurance policies are considered a return of premium and are not taxable up to the amount of premiums paid. This applies as long as cumulative dividends do not exceed total premiums paid. If dividends, or interest earned on them, exceed total premiums, the excess becomes taxable income.

Life Insurance and Estate Taxation

While life insurance death benefits are exempt from income tax for beneficiaries, the policy’s value can be included in the deceased policyholder’s taxable estate for federal estate tax purposes. This is a separate consideration from income tax and applies to estates exceeding certain federal exemption thresholds, which are subject to change by law.

A life insurance policy’s value is included in the gross estate if the deceased owned the policy at the time of death or possessed “incidents of ownership.” Incidents of ownership refer to any economic control over the policy, such as the right to change beneficiaries, assign the policy, pledge it as collateral for a loan, or surrender or cancel it. Even if never exercised, merely having these rights at death can cause policy proceeds to be included in the estate.

Additionally, if the deceased’s estate is named as the beneficiary, the death benefit will be included in the taxable estate regardless of who owned the policy. The “three-year rule” also applies: if a policy is transferred out of the insured’s ownership within three years of death, the death benefit may still be included in their taxable estate.

To remove life insurance proceeds from a taxable estate, an Irrevocable Life Insurance Trust (ILIT) can be used. An ILIT is a legal entity designed to own the policy, removing it from the insured’s personal estate. When properly structured, the ILIT becomes the owner and beneficiary. Upon the insured’s death, proceeds are paid directly to the trust, which then distributes them according to its terms. This arrangement helps avoid federal estate taxation, providing liquidity to heirs without increasing the estate’s tax burden.