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Individually, life insurance and taxes are complicated. When they intersect, it may be difficult to know what lies ahead: tax-free income or a big tax bill?
The good news is that life insurance payouts to individuals generally aren’t subject to federal income tax.
But that doesn’t mean life insurance never affects federal taxes. Let’s discuss some situations when payouts are and aren’t taxable, when premiums may be part of your tax bill — and how to best protect your loved ones from a potential tax liability.
- When is a life insurance payout not taxable?
- When is a payout taxable?
- Are life insurance payouts subject to estate tax?
- When are life insurance premiums taxable?
- Next steps: Ways to protect life insurance proceeds
When is a life insurance payout not taxable?
Generally, life insurance benefits paid out to individual beneficiaries aren’t subject to federal income tax. That’s because you don’t have to include life insurance payouts in your gross income or report them to the IRS.
Let’s consider an example: You’re the beneficiary on someone else’s policy, such as a parent or spouse, and receive a payout from the policy when the covered person passes away. Because you’re the named beneficiary, you won’t have to pay federal income tax on that payout.
If you’re the person covered by the policy, have a terminal illness and are receiving accelerated death benefits (paid out to you while you’re still alive), those generally aren’t taxable either.
When is a payout taxable?
But as we mentioned above, in certain situations, you may have to pay tax on all or a portion of life insurance proceeds.
Interest is taxable
If you receive a life insurance payout that has accrued interest, you’ll likely have to pay tax on that interest. This could happen if the policy is set up for the insurer to hold onto the payout at the time of the policy holder’s death and release it to the beneficiary after a set amount of time. Or, this rule may apply if you choose to receive the payout in installments and the carrier pays interest.
Cash surrender is partially taxable
When you surrender a policy for cash, you may have to pay tax on any proceeds that exceed the cost of the policy. This usually includes the total amount in premiums that you paid for the policy, minus any rebates, dividends, unrepaid loans or refunded premiums that aren’t otherwise included in the income you report to the IRS.
Transfer of policy is partially taxable
If you pay cash or other compensation to have a policy transferred to you (rather than receiving a standard payout), you’ll likely have to pay federal income tax on the portion of the policy value that exceeds the amount you pay for the transfer (plus any premiums you pay and certain other taxable amounts). For example, if you’ve paid $5,000 to take possession of a policy with a $45,000 death benefit, and didn’t pay any premiums or other qualifying amounts, you’ll probably have to pay tax on $40,000.
Are life insurance payouts subject to estate tax?
Like the name says, estate tax can apply to an individual’s estate, which the IRS considers to be everything a person owns or has an interest in when they die.
Based on that definition, life insurance proceeds paid out to a beneficiary don’t count as part of their estate — because that money doesn’t belong to the insured. It belongs to their beneficiaries after the insured person passes away.
But if the policy pays the death benefit to the covered person’s estate, rather than a beneficiary, it’s possible that the amount could be subject to estate tax.
Large estates worth $11.58 million or more (the 2020 threshold) can be subject to federal estate taxes. But few estates are that large. In 2018, just 0.19% of estates were subject to federal estate tax, according to a Tax Policy Center analysis of federal data.
When are life insurance premiums taxable?
While life insurance payouts generally aren’t taxable if you’re the beneficiary, it’s possible for some group life insurance premiums to be subject to federal income tax.
If your employer gives you group term life insurance coverage of more than $50,000 as a fringe benefit, you may have to include the premiums for that coverage in your income, less any contributions you made toward the plan during the tax year. But if the life insurance death benefit is for less than $50,000, you generally don’t have to include the premiums as income.
Next steps: Ways to protect life insurance proceeds
Life insurance is a way for you to help protect your loved ones financially after you’re gone. The simplest way to help them avoid paying tax on the payout from your life insurance is to name them as beneficiaries, rather than naming your estate.
But if your financial situation is complex, or your estate may be subject to estate taxes, it’s probably a good idea to consult a financial adviser or tax professional who can counsel you on ways to minimize tax impact, such as an irrevocable life insurance trust. And a life insurance specialist may be able to help you understand what life insurance products are best for your specific situation.
Relevant sources: IRS: Life Insurance & Disability Insurance Proceeds | IRS Publication 525: Taxable and Nontaxable Income (2019) | IRS: Estate Tax | IRS Publication 559: Survivors, Executors and Administrators (2019)
Christina Taylor is senior manager of tax operations for Credit Karma Tax®. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is an Enrolled Agent, the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.