Is Life Insurance Taxable?

If you receive a payout as the beneficiary of a life insurance policy, you may be wondering if this benefit is considered taxable income by the IRS. The answer to this question is often situational and is dependent on variables pertaining to both the type of policy and the wishes of the policyholder. Here’s a look at what to expect and prepare for regarding the benefits you’ve received. 

Is Life Insurance Taxable?

Typically, any sum of money you receive as a beneficiary from a life insurance policy is not considered taxable income. But there are circumstances that can change that. It’s important to understand that while the payout itself may not be taxable, any interest that it accrues is.

A policyholder may elect for the life insurance provider to hold the death benefit funds for a given period of time after their death rather than pay it out to the beneficiary immediately. In this event, the funds may generate interest. If that interest is received as income by the beneficiary, they may have to pay taxes on it.

Additionally, if the policyholder has arranged for the beneficiary to be an estate rather than a sole individual, the person inheriting the estate may be required to pay estate taxes on it. There are, however, exceptions to the rule — estate taxation can be avoided if ownership of the policy is transferred to another individual or entity. In this event, prospective new owners must complete the proper assignment forms and pay the policy premiums.

In the case of cash value life insurance policies, the policy holder may be able to access funds that have accrued over time via a withdrawal or by surrendering the policy and ending it. With cash value accounts, money builds up within the policy tax-free based on interest and investment gains. However, you may be taxed upon withdrawal of funds. Loans based on life insurance cash value, on the other hand, are not taxed as long as the policy is still in effect.

If a policyholder decides to terminate their coverage and surrender their policy, they’ll receive what’s called the “surrender value” of the policy. That's the policy’s current cash value minus any applicable surrender charge. In this situation, the IRS won’t tax on the entire surrender value of the account. The tax is usually based on the amount you received minus what you paid into premiums so far. That's because a case can be made that part of the value you received is simply a refund of premiums.

In the event that a terminally ill policyholder reaches a viatical settlement with another individual or entity and sells their life insurance policy, the IRS doesn’t treat any portion of this settlement as taxable according to IRS code 101 (g)(2). Because the policyholder is seen as having a short life expectancy, the IRS views this kind of transaction in the same light as a standard death benefit. If you are not terminally ill, however, the IRS is at liberty to tax a portion of whatever you may receive for your life settlement.

If you hold a policy with a modified endowment contract (MEC), some different tax rules may apply to your situation, and it’s best to contact a financial professional.

How Do I Avoid Tax on Life Insurance Proceeds?

As mentioned above in regards to estate beneficiaries, policy ownership transfers are one method of avoiding taxation. Once the new owner has completed the necessary forms and paid their premiums, the original policyholder surrenders all rights to make any further changes to the policy, as ownership transfer is irrevocable.

Another method of avoiding taxation is to create an irrevocable life insurance trust, or ILIT. In this case, the original policyholder is no longer seen as the sole owner of the account but doesn’t surrender all legal control over the policy. Rather, an ILIT allows the policyholder to name a trustee to handle the funds under the terms and conditions of a trust document. 

Is Life Insurance Money Considered Part of an Estate?

If the policyholder makes “payable to my estate” the name of the beneficiary on their account, then the policy funds will be considered part of an estate. While this does increase the value of the policyholder’s estate, it negates the opportunity to name a sole individual as the beneficiary, and thus may subject the policy payout to estate taxes. 

Several useful resources exist for individuals trying to calculate their life insurance needs or determine if their policy proceeds are taxable. HelpAdvisor can be a great asset in helping you determine what your needs are in a life insurance policy, and the official IRS website’s Interactive Tax Assistant can assist you in ascertaining what aspects of your policy may be potentially taxable. 

Because taxes are a complicated matter, you may also want to consult with a professional as you plan for your estate and purchase life insurance for any reason.