Do beneficiaries have to pay taxes on life insurance?

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While life insurance is an important purchase because it can help secure your family’s or other loved ones’ financial future after your death, it’s far from the only use case. Some people choose to use life insurance policies as an investment vehicle or as a part of their retirement planning. Others simply choose to purchase life insurance as a way to offset funeral costs.

No matter how you plan on using your life insurance policy, there are some key questions that often get asked: Do you have to pay taxes on life insurance benefits? Are life insurance proceeds subject to income tax or other forms of penalty?

At SelectQuote, we help our customers find answers to all manner of insurance questions, from how to buy coverage to how to navigate life insurance fees and taxes. Let’s walk through situations where life insurance beneficiaries may need to be aware of tax concerns after receiving a payout from a policy.

When do beneficiaries pay taxes on life insurance payouts?

The good news: generally speaking, life insurance proceeds aren’t counted as taxable income. If you’re the beneficiary of a hefty life insurance policy—such as a $1 million term life policy—you can (mostly) rejoice. 

However, depending on how you use the funds or how they are dispersed to you, you may be subject to taxes on the life insurance payout. Rare situations in which taxes apply to life insurance benefits can include:

  • The life insurance company issues the death benefit as installments versus a lump sum
  • The death benefit is added to your estate
  • More than two people are involved in the policy

The insurance company issues the death benefit in installments.

If the insurer delivers the death benefit in installments versus a lump sum, you may have to pay taxes. The reasoning behind this? An insurer who issues the installments may hold the principal amount in an interest-bearing account while issuing a percentage of the payout over a period of years. The interest that accumulates as a result will be subject to income taxes.

Types of Taxes that Impact Life Insurance Payouts

Even if life insurance isn’t generally taxable, it’s important to know the differences between the three main taxes that could come into play with any life insurance policy.

Estate Taxes and Life Insurance

You typically only have to worry about the estate tax if your estate’s total taxable value exceeds $11.7 million. In addition, most proceeds from life insurance are exempt from estate taxes if left directly to your spouse. 

If you own your life insurance policy at death, the IRS can include the payout as part of your estate regardless of a named beneficiary. This could push the total taxable value over the threshold. In addition, some states impose their own estate taxes with varying exemptions. The estate tax rate will vary from state to state.

One way to avoid this is to transfer ownership of your policy to another party before you die. This process typically takes three years to take hold before the policy is considered to have changed hands.

Inheritance Tax and Life Insurance

The inheritance tax is placed on recipients for the inheritance of cash payouts, property or other assets. Only six states enforce the inheritance tax:

  • Iowa
  • Kentucky
  • Nebraska
  • New Jersey
  • Maryland
  • Pennsylvania

Gift Tax and Life Insurance

The death benefit of a life insurance policy may be subject to a gift tax if different people are involved in the main roles of the policy:

  1. The insured: the person covered by the policy.
  2. The policy owner: The person who buys the policy.
  3. The beneficiary: the person who receives the death benefit.

In most cases, only the insured and the beneficiary are involved in resolving a life insurance claim. But if a different person is involved as the policy owner, the process is slightly more complicated. 

For example, if your wife buys life insurance on you, but names your child as the beneficiary, the proceeds from the policy are a gift from your wife to your child. And while it’s usually rare for gift taxes to be paid, it’s still a good idea to report any and all large gifts on your income taxes to keep track of the totals.

Paying Interest on Life Insurance

If your permanent life insurance or whole life insurance policy involves a cash value that you can borrow against, you may need to pay interest on the loaned amount over time. In addition, cash values can accumulate interest, and in these cases you will likely need to pay taxes on the proceeds.

Do you pay taxes on life insurance cash value payouts?

For the most part, the cash value of a whole life insurance policy is tax-deferred. This means you only pay taxes on the amount if you access it. The IRS will levy the tax on the amount that exceeds your policy basis: the sum of your previously paid life insurance premiums minus any dividends you might receive.

Withdrawing less than the policy basis makes the cash value tax-free money. Any withdrawal that exceeds your policy basis is subject to income tax. But withdrawing money from the cash value can have a side effect, which is the reduction of your death benefit. Weigh the costs of withdrawing money today and how those costs will impact your beneficiaries.

SelectQuote Can Help Answer Your Life Insurance Tax Questions

SelectQuote can help answer your questions if you’re worried about the tax implications of a life insurance policy. Whether you need a term life insurance policy to help provide some financial cushion for your family or you’re a wealthy individual in need of a massive life insurance policy to help take care of any remaining business, let us walk you through your unique needs. 

We’ll compare quotes from several life insurance companies at once and help find the right policy for your situation.

We do the shopping. You do the saving.