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Are Life Insurance Proceeds Taxable?

Benjamin Franklin once wrote: “In this world nothing can be said to be certain, except death and taxes.” Old Ben must have been the life of the party back in the day! On the other hand, he kinda 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? Is a life insurance payout taxable?

If you’re wondering about the taxman’s plans for your policy (you do have a life insurance policy to provide for your family if something happens to you, right?), we’re going to talk through all the scenarios for this key protection and the few times when taxes come into play.

Is Life Insurance Taxable?

The good news is that life insurance proceeds are almost never taxable—so maybe we’ve found an exception to Ben’s rule! Typically speaking, if you’re the beneficiary of a life insurance policy, you probably won’t owe any taxes on the death benefit. But there are a few times when taxes creep in. We’re going to explain each scenario—for both taxable and untaxable cases—in detail below.

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Types of Taxes You Need to Know

Before we explain the tax events that sometimes affect life insurance proceeds, let’s get a handle on the different types of taxes that come into play.

  • Income Tax – This kind of tax hits you every year and is probably already pretty familiar. It’s just the federal—or in some places state—tax on the income of an individual or married couple. The IRS takes whatever you’ve earned during the year, allows you to 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, the federal government and some states combine all the assets of the deceased (property, investments, annuities and life insurance), subtract all that is owed (loans, medical bills and credit cards), and tax the final number. This tax is paid from the estate itself, not the individuals involved. But let’s soften the blow: Most estates are not affected by this federal tax because, as of 2021, only those estates valued over $11.7 million have to pay.1 Each state that has an estate tax also has its own exemption 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 is state tax put on a person who receives an inheritance. All spouses are exempt from this tax, but some states will tax children or domestic partners. Since it’s so rare, you’re probably not affected by it, but go ahead and check to see if you live in one of the states that has an inheritance tax.
     
  • Generation-Skipping Tax – This one might be a no-brainer if you look closely at the term. Basically, it’s a tax applied when an inheritance is given to 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).3 This tax can also be applied to money given to a skip person through a trust.

When Is Life Insurance Not Taxable?

Like we said, most of the time life insurance is not taxable. So before looking at the rare exceptions, let’s enjoy talking about all the times when your payout is safe, and you don’t have to worry about the taxability of life insurance proceeds.

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 (called the death benefit) 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 the estate above a certain limit ($11.7 million in 2021, or $12.06 million in 2022), no estate taxes would be owed.4

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), you have an added cash value account associated with 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, which is highly doubtful.

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. It’s kinda like cannibalizing your life insurance by eating away at the provision you’ve established for your family. Again, these policies are just bad news in general. But at least there are no taxes to pay on partial withdrawals.

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 receive 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 would be if the total payouts added up to more than what you paid in premiums in a single year.

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. What would happen with the money in your cash value account? And more importantly, would it be taxable?

In that situation, you’d be given a lump sum from the insurance company, but you wouldn’t owe any taxes—unless the payout was larger than what you’d already paid in. That almost never happens, so neither do the taxes. Yay!

When You Accelerate Your Death Benefit

If you’re up against a wall because you become chronically or terminally ill, you’ll need all the help you can get. And in such times, you may have the option to “accelerate” your death benefit. Essentially, you’d be considered your own beneficiary, and you’d receive some or all of your death benefit early. This approach can be a godsend in certain circumstances. But you only want to do this if you’ve become self-insured through savings and investments and you’re confident your loved ones are going to be taken care of when you’re gone.

To receive an accelerated death benefit, many companies require you to provide them with documentation 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.

When Is Life Insurance Taxable?

As you can see, most of the time a life insurance payout is not taxable. But once in a blue moon, 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 and 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!

But with parties of three, the tax man comes crashing in. For example, say Walt (the owner) buys a life insurance policy on his son Johnny (the insured). But then Walt 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.

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. If this figure is over $11.7 million (for 2021), the estate will have to pay taxes. 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! Why do Ben’s words on death and taxes keep sounding like prophecy? (It’s because they pretty much are.)

When You Profit From Surrendering Your Cash Value Policy

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. Make sure the term 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 will not be considered part of the estate of the insured, which lowers the estate value and the potential for estate taxes.

The trust itself has its own tax ID number and will receive the death benefit directly at the death of the insured. Afterward, 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.

Here are two ways to look at trusts and taxes:

  1. If you set up the irrevocable trust from the beginning as the owner and the beneficiary of the life insurance policy, then the death benefit is in force with no taxes due from day one.
  2. If, however, you set up the trust and transfer the policy into the trust, a three-year implementation period comes into play to prevent people from undertaking last-minute sneakiness as a tax loophole.5

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. It will be available for your heirs to use to pay any estate taxes on your other assets. But it’s really not practical except for estates worth over the magic number of $11.7 million (as of 2021) and should be set up by an estate law professional who does this all the time. 

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 Heath 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 can even recommend a local one close by. Do yourself a favor and work with a competent tax pro.

And what about life insurance? There are a host of options. We’ve talked about a ton of them here, but when you’re ready to toss your permanent insurance policy and get a term policy, get help from a professional. Be sure to contact the company Dave Ramsey trusts and recommends—Zander Insurance.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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