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Benjamin Franklin once wrote: “In this world nothing can be said to be certain, except death and taxes.” Now that’s what we call a buzzkill! On the other hand, he kind of had a point—we all need to make plans for death and taxes. Life insurance is great protection in the event of the first, but what about the second? Do you have to pay taxes on life insurance?
The good news is that life insurance proceeds are almost never taxable—so maybe we’ve found an exception to Ben’s rule!
If you’re wondering about the taxman’s plans for your policy (and oh, by the way, you almost definitely need life insurance to provide for your family if something happens to you), we’ll talk through all the scenarios where taxes and life insurance do—and don’t—collide.
Is a Life Insurance Payout Taxable?
Typically speaking, if you’re the beneficiary of a life insurance policy, you probably won’t owe any taxes on the death benefit (aka payout). But there are a few times when taxes creep in. We’ll explain each scenario—for both taxable and untaxable cases—in detail below.
Life Insurance Tax Types You Need to Know
Before we explain the tax events that sometimes affect a life insurance payout, let’s get a handle on the different types of taxes that could come into play.
- Income Tax: You have to deal with this kind of tax every year, so it’s probably pretty familiar territory. It’s just the federal—or in some places state—tax on your income. The IRS takes whatever you’ve earned during the year, lets you deduct certain expenses, and decides what you owe based on your net income tax bracket.
- Estate Tax: Benjamin’s wisdom on death and taxes strikes again! Basically, when a person dies, the federal government and some states add up the value of all their assets (property, investments, annuities and life insurance), subtract all their outstanding debt (loans, medical bills and credit cards), and tax the final number. An estate tax is paid from the estate itself, not the people who inherit it. But there’s great news for most folks: Most estates are not affected by this federal tax because, as of 2023, only those estates valued over $12.92 million have to pay.1 And even the states that have an estate tax don’t tax estates valued under a certain amount—ranging anywhere from $1 million to $7.1 million.2
- Inheritance Tax: The only thing to celebrate here is how few people this affects. An inheritance tax is a bit different because it’s a state tax on inheritances that’s paid by the heir. Thankfully only six states charge this kind of tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.3 Even better, all spouses are exempt from this tax, and in most cases parents and children are exempt as well. The only time the inheritance tax comes into play is in the six states listed—and even there, it only applies to certain kinds of heirs. Since it’s so rare, you’re probably not affected by it, but if you do live in one of those six, check to see which kinds of heirs might face an inheritance tax.
- Generation-Skipping Tax: The name pretty much says it all on this one. Basically, it’s a tax on an inheritance when the heir is someone other than the next immediate descendant, or a “skip person,” whether that person is in the family or not. For example, a grandfather could “skip” his own child and leave an inheritance to his granddaughter (or a relative who’s at least 37 1/2 years younger than the deceased).4 This tax can also apply to money a skip person inherits through a trust.
When Is Life Insurance Not Taxable?
Like we said, most of the time life insurance is not taxable. Later we’ll talk about the rare exceptions, but first let’s have a little fun talking about all the times you don’t have to worry about paying tax on a life insurance payout.
When Your Beneficiary Gets a Payout in a Lump Sum
In hard times, every piece of good news helps. When your spouse or other designated beneficiary gets their payout for your life insurance, no matter how big it is, they won’t owe any income taxes on it. Whew! At least that’s one less worry.
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Now what if you somehow forgot to specify a beneficiary in the life insurance policy? In that case, the death benefit is considered part of your estate. So, is it taxable? In most cases, no. As long as the payout doesn’t push the total value of your estate above a certain limit ($12.06 million in 2022, or $12.92 million in 2023,), your family won’t owe estate taxes.5
When Your Beneficiary Receives a Gain in Cash Value
If you have cash value life insurance (as opposed to term life insurance, which is the type we recommend), an added cash value account is part of your policy. When the policy holder dies, the full cash value goes back to the insurance company. (See why we don’t recommend this type of policy?) Obviously, nobody gets taxed when they’re not getting paid.
In some very rare cases, an insurance company will agree to sell a policy that pays out some cash value to the beneficiaries upon your death. If that’s your situation, good news! The beneficiaries still won’t pay income tax—unless the amount they receive exceeds the total amount you’ve paid into the policy over the years. (Trust us, it almost never happens!)
When You Make a Partial Withdrawal From the Cash Value of Permanent Insurance
Say you have a cash value policy. While you’re still living, you can make a partial withdrawal from the cash value portion of your account, and this amount is not taxable. Now, if you don’t pay it back before your death, that amount will be subtracted from the death benefit before your beneficiaries receive a dime. In a way though, you’re defeating your own best-laid plans. How so?
It’s kind of like cannibalizing your life insurance by eating away at the payout amount your family is supposed to receive. Again, these policies are just bad news in general. But there are no taxes to pay on partial withdrawals, so at least you’ve got that going for you.
When You Receive Annual Dividends
Some insurance companies are called “mutual” insurance companies because the policyholders own the company “mutually.” (Just so you know, it’s a gimmick combining a bad investment with a worse kind of insurance.) Anyway. The shared owners in these setups earn annual cash dividends based on the profit of the company. This is another example of tax-free life insurance proceeds. The only way those dividends would become taxable is if the total payouts add up to more than what you paid in premiums in a single year—another very unlikely scenario.
When You Surrender Your Permanent Life Insurance Policy
If you’ve read the last couple of sections, you’re probably realizing how much of a rip-off cash value (also known as permanent) life insurance policies are. In that case, you’d be smart to turn in, or “surrender,” that terrible policy for a less expensive term life insurance policy. But what happens to the money in your cash value account when you do that? And more importantly, would it be taxable?
In that situation, you’d receive a lump sum from the insurance company, but you wouldn’t owe any taxes—unless the cash value was larger than what you’d already paid in premiums (called the policy basis). When you consider how many fees you pay at the start of a permanent policy, plus how slowly the cash value grows due to low ROI, you can see that ending up with more cash than premiums paid is rare. But if you’ve had the policy for a while, your cash value might have exceeded your policy basis—and in that case, the IRS sees the difference as taxable investment gains.
When You Accelerate Your Death Benefit
If you’re up against a wall financially because you’ve become chronically or terminally ill, you’ll need all the help you can get. In times like that, you may have the option to “accelerate” your death benefit. So how does that work? You’d be considered your own beneficiary, and you’d receive some or all of your death benefit early. This move can be a godsend in certain circumstances.
But hear us on this: You only want to do an accelerated death benefit if you’ve become self-insured through savings and investments and you’re confident your loved ones will be taken care of when you’re gone.
To receive an accelerated death benefit, many companies require you to provide them with documentation (something from a doctor) of a terminal illness and a life expectancy under two years. Either way, you become the beneficiary of your own life insurance policy, and normally your proceeds here would not be taxed.
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When Is Life Insurance Taxable?
As you can see, most of the time a life insurance payout is not taxable. But there are rare cases when you will see taxes kick in. Here are a couple of those instances.
When Three People Are Involved
There are really only three roles in a life insurance policy:
- The owner of the policy
- The insured person
- The beneficiary
Usually, the first two roles are filled by the same person—for example, when the owner is the insured person. In those common cases, there’s no tax! Sweet!
But with parties of three, the tax man comes crashing in. For example, say Richard (the owner) buys a life insurance policy on his son Jake (the insured). But then Richard names his daughter-in-law Jolene as the beneficiary. It’s a loving gesture, but it might not be a wise tax move for Jolene. Why not? Because in that case, the death benefit is taxable income for her. Ouch!
When Your Beneficiary Takes the Payout in Installments
A life insurance payout is almost always paid to the beneficiary as a single lump sum. But some policies allow the beneficiary to decide if they want the money paid out in installments. As the beneficiary, maybe you prefer a steady income to getting it all in one pot, and that’s your choice! But you need to know, if you go that route, it could involve some taxes.
First, the principal amount of the payout (which just means the balance waiting to be paid to you over time) sometimes goes into an interest-bearing account. In other words, it starts earning a little money. And once that happens, your interest earnings will be subject to income tax.
The good news is that if you do choose installments, the original death benefit amount is usually not—repeat not—going to be taxed.
When Your Estate Exceeds the Estate Tax Threshold
If your spouse or children are named as the beneficiaries of your life insurance, the death benefit is not counted as part of your estate. But if it’s paid to a skip person (see above) or not specified, it will be included in the value of your estate. For 2023, if this figure is over $12.92 million (for individuals) or over $25.84 million (for couples), the estate will have to pay taxes.6 Remember to check with your state laws, too, because some have their own estate tax.
When You Sell a Life Insurance Policy
If you decide to sell a permanent life insurance policy and replace it with term life coverage, you’ll be doing yourself a big favor. But keep this in mind: The agent or broker selling it on your behalf will take a cut from the amount you receive. And don't expect to get back the amount you're covered for when you die (the death benefit). You'll get back less than that, and if the amount you do receive totals more than all the premiums you've paid over the years, the news gets worse—you'll pay income tax on it! Yikes! Maybe Ben’s words on death and taxes have returned to haunt us?
When You Take a Loan Against the Cash Value
We never recommend taking loans out for any reason. But taking one out on the cash value of a worthless whole life policy? That’s several bad choices in a single move!
Borrowing against the cash value of a whole life policy is a terrible idea, but it is technically an option if you have such a policy—something (to be crystal clear) we do not recommend! But let’s say you already have a loan like this. There are a couple of awful things you could end up facing in the future. First, if the amount you owe ever exceeds the cash value of the policy, the whole thing will be canceled. Bye-bye skimpy coverage!
Picture yourself without life insurance, and still owing money on the loan you took out against it! Ready for more bad news? Guess how the insurance company covers your outstanding debt? They’ll immediately suck up your cash value to cover the loan. Could it get worse? Yes! You can also expect an immediate tax bill from the cash value you used to “pay” for your loan.
Here’s one more little bit of bad news we want to mention, even though it’s not a tax—if you die still owing on the policy loan, the insurer will deduct the balance from your death benefit. Please do not get cash value life insurance, and if you’re somehow already stuck in a policy, never borrow against it!
When You Profit From Surrendering Your Cash Value Policy
Let’s say after you read this article and found out all the reasons not to have a whole life insurance policy, you decide to get rid of it and buy term life insurance instead. Great move! But there’s a slim chance you’ll have to deal with Uncle Sam as a result. After buying a replacement term life policy, getting the payout from your cash value account, and then surrendering your permanent life policy, you may owe taxes. Bummer! If the amount you receive is more than what you’ve paid in fees and premiums over the life of the policy (fat chance!), you’ll need to report that amount as extra income. But take heart—this hardly ever happens.
Note: The order here is important. You never want to be even a moment without life insurance coverage. Don’t worry if you’re double-covered for a few days with both whole and term insurance. It’s always better to have too much coverage than not enough. Make sure your term life policy is in force before surrendering your whole life and receiving the cash value amount.
Can I Use an Irrevocable Trust to Shield My Death Benefit From Taxes?
Some people with larger estates may consider naming the beneficiary in their life insurance policy as an irrevocable trust. This way, the life insurance payout won’t be considered part of the estate, which lowers the estate value and the potential for estate taxes.
So how does that all work? First, the trust itself gets its own tax ID number and receives the death benefit directly when the insured person dies. Next, the trustee of the trust will distribute the funds to the beneficiaries named in the trust. Even a skip person will escape paying income taxes on the trust assets they receive. Freedom!
Here are two ways to look at trusts and taxes:
- If the irrevocable trust is set up as the owner and beneficiary of the life insurance policy from the beginning, then the death benefit is in force with no taxes due from day one.
- If, however, you set up the trust and transfer the policy into the trust, there’s a three-year implementation period before the payout would be protected from taxes. It’s Uncle Sam’s way of keeping people from last-minute sneakiness to avoid taxes.7
If you can set up a trust so that all the i’s are dotted and the t’s are crossed, it’s all good. The death benefit will be available for your heirs to use to pay any estate taxes on your other assets. But this kind of thing really isn’t practical except for estates worth over the magic number of $12.92 million (as of 2023) and should be set up by an estate law professional who does this all the time. You absolutely don’t want to risk being hit with an estate-wiping tax bill through amateur trust management!
Are Life Insurance Premiums Tax Deductible?
Uncle Sam considers your monthly premiums a personal expense, so they can’t be deducted when calculating your taxable income. And they can’t be paid using your Health Savings Account (HSA) either. Good try, though!
Face it: Ben was right about the two things that are almost always with us in this world. Whatever your specific tax situation, you’ll want to talk to somebody who handles this stuff every day. We’ve vetted some of the best tax pros in the country and are proud to call them RamseyTrusted. Do yourself a favor and work with a competent tax pro.
And what about life insurance? If you’re in the market for new life insurance or want to talk to an expert, we recommend RamseyTrusted partner Zander Insurance. Don’t let another day go by without being protected.
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Why Should You Trust Our RamseyTrusted Brokers From Zander Insurance?
You can trust the brokers from Zander to help you get the best life insurance for your stage of life because everyone we endorse is RamseyTrusted. If you don’t know what that means, it’s this: They’re advocates for Ramsey's financial and business principles. They know their job is to serve—not sell. And before getting the seal of approval, each is fully vetted by our team. They have to earn our trust, and we make sure they keep it through an ongoing relationship.