Is My Life Insurance Policy Taxable in 2023?
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Generally, a life insurance death benefit is not taxable but there are a few exceptions if you have a permanent life policy. Any income you earn above the total premiums you’ve paid — usually from interest or the sale of the policy — is considered taxable income. Additionally, taxes may apply if you designate your estate as the beneficiary.
In this article, we will list taxable scenarios related to life insurance plus examples.
Are Life Insurance Payouts Taxable?
In most cases, the IRS does not classify the death benefit from a life insurance policy as taxable gross income and the beneficiary will not need to report it on their annual tax return.
However, there are some situations when the payout may be subject to taxes, especially if you have a permanent life policy like whole life insurance. Specifically, you will need to look at the policy basis — your total premiums minus dividends earned.
Additionally, listing your estate as the beneficiary can create a taxable event.
Is Term Life Insurance Taxable?
The death benefit in a term life insurance policy is usually not taxable so long as your beneficiary is your spouse or child over 18. However, if you choose your estate as your beneficiary, then it may be subject to an estate administration tax. Listing “payable to my estate” as your primary beneficiary means the death benefit can go through probate court and it may even be used to pay outstanding debts. Whatever is leftover (if anything) will go to your loved ones.
Is Whole Life Insurance Taxable?
Similar to term life, the death benefit of a whole life insurance policy is generally not taxable if an actual individual is listed as the beneficiary. However, its cash value component can have tax implications.
If you borrow against the cash value and don’t repay it or if you surrender the policy to cash it out, any portion that exceeds the policy basis is subject to taxes.
This applies to other types of life insurance with lifelong coverage like universal or variable life policy. You should consider this added complexity when choosing if life insurance is right for you.
Is Employer-Paid Group Life Insurance Taxable?
The employee will not have to pay taxes if employer-provided life insurance coverage is $50,000 or lower. If the coverage is higher than $50,000 then taxes will apply on the premiums paid to purchase coverage in excess of that $50,000 threshold. The premium difference is used because it is the taxable benefit enjoyed by the employee.
Example: Jane started a new job and is provided with a $75,000 life insurance benefit as part of her overall compensation package. The employer pays $60 per month to provide this life insurance coverage but only $20 of it pays to increase the coverage from $50,000 to $75,000. As a result, Jane has to pay taxes on only the monthly $20 ($240 per year) — the amount to purchase coverage in excess of the IRS threshold of $50,000.
Jane would not have to pay taxes on the $40 used to buy $50,000 of coverage, which meets the IRS threshold.
Are Life Insurance Dividends Taxable?
Life insurance dividends are usually not taxable as long as they are not greater than the premiums you have paid into the policy. In fact, the IRS considers dividends as a return of your premium and instructs policyholders to subtract dividends from their total premiums when calculating their policy basis. However, if over the years the total dividends earned somehow exceeds the total premium paid, then the difference would be subject to taxes.
Are Accelerated Death Benefits or Viatical Settlements Taxable?
An accelerated death benefit is a rider that allows the insured to receive their life insurance money while they are still living. A viatical settlement, on the other hand, involves the sale of a life insurance contract to a third party.
In either case, the insured often suffers from a chronic or terminal illness and needs the death benefit or sale proceeds to pay for costly hospital and medical treatment. If the insured has a terminal illness, then the payout is generally tax-free. However, a limit can apply if the insured has a chronic illness that is not terminal.
Is the Cash Value in Permanent Life Insurance Policies Taxable?
The cash value in a permanent life insurance policy is generally not taxable unless it is withdrawn and it exceeds the policy basis, or cost of the policy (total premiums paid, less dividends earned).
Example: Mark has a life insurance policy with $12,000 in cash value and has paid $7,000 in premiums to date. Mark decides to surrender the policy for the cash value. As a result, he has to pay taxes on the $5,000 difference because it exceeds the amount he paid into the policy ($7,000 in premiums).
Keep in mind that with some cash value policies, the insurer keeps the accumulated cash value when you die. Your beneficiary will receive only the death benefit. Be sure to confirm who gets the cash value when you die before buying the policy.
Life Insurance Tax Types
There are a few different types of taxes related to life insurance, including estate taxes, income taxes, and capital gains taxes.
- Estate taxes are owed if you designate your estate as the beneficiary — we do not recommend this and you should designate an individual like your spouse instead.
- Income taxes may be owed on the interest or dividends earned from a life insurance policy.
- Capital gains taxes typically only apply when you sell a life insurance policy.
In the next section, we’ll spell out specific scenarios in which taxes may need to be paid when it comes to life insurance.
When Do You Pay Taxes on Life Insurance?
Beneficiaries may owe taxes on their life insurance payout depending on how the death benefit payout was structured and on any income earned above the policy basis. Additionally, taxes may apply if the death benefit is payable to the insured’s estate.
Beneficiary Chooses Installment Payments
If the beneficiary chooses to receive the death benefit in installments instead of a single lump sum, it can create a taxable event. The beneficiary will need to report a part of each installment but can exclude a portion.
To calculate how much you can exclude from your taxable income, divide the total lump sum by the number of installments. Any amount that is higher than this calculation is considered interest and must be reported as taxable income.
Example calculation: The death benefit is $100,000 and the beneficiary chooses to receive 100 monthly installments of $1,200. To calculate the amount that is excludable from income, divide $100,000 by 100 which equals $1,000. The remaining $200 each month ($1,200-$1,000) is taxable income and must be reported as interest income. Over 12 months, this would be $2,400 that should be reported on the beneficiary’s income tax return.
If you are a surviving spouse receiving life insurance proceeds from a spouse who died before October 23, 1986, you are allowed to exclude up to $1,000 a year of the interest income mentioned above, even if you remarry. Using the earlier example, the beneficiary would only have to pay taxes on $1,400 ($2,400-$1,000) of the interest income.
Beneficiary Delays the Death Benefit
If the beneficiary waits to receive the death benefit instead of receiving it promptly after the insured’s death, then any interest the delayed death benefit earns is subject to taxation. Keep in mind the taxes are only levied on the interest, not on the entire benefit amount.
Example: James is entitled to a death benefit of $750,000 and waits one year before he decides to receive it. Over one year, it earned 5% interest which increased the amount to $787,500. As a result, James must pay taxes on the $37,500 growth and not the $750,000 death benefit.
Policyholder Doesn't Repay a Cash Value Loan
You can borrow from your life insurance policy through cash value loans and the borrowed amount is not taxable if you repay it. However, failing to repay the loan can create a taxable event for any amount that exceeds the policy basis.
Example: Ryan’s life insurance policy has $8,000 in cash value and the policy basis is $3,000. Ryan borrows $7,000 from the policy. Normally, Ryan would not have to pay taxes on the additional $4,000 assuming he repays the loan. However, Ryan falls behind on his premium payments and does not repay the loan so his life insurer cancels the policy. As a result, Ryan must report the $4,000 as taxable income on his income tax return.
Policyholder Surrenders the Policy for the Cash Value
Surrendering the policy means canceling the policy to withdraw the accrued cash value. Any amount that exceeds the policy basis is taxable income. That means if the amount you withdraw is over the total premiums you paid minus dividends or unrepaid loans, then the difference must be reported on your income tax return.
Example: Sarah has a variable life insurance policy that has accumulated $15,000 in cash value and she has paid $10,000 in premiums over the years. Sarah decides to surrender the policy for the cash value. As a result, she would have to pay taxes on the $5,000 difference because it exceeds the basis of $10,000 (total premiums paid).
Policyholder Sells the Policy
When selling a life insurance policy, the seller should be aware that taxes can apply to the proceeds received. Proceeds in excess of the policy basis up to the cash surrender value of the policy are taxed as ordinary income. Any remaining proceeds are taxed as capital gains.
To estimate the amount taxed as ordinary income, subtract the total premium paid from the policy's cash value. So, if the policy basis was $25,000 and the cash value amount was $30,000, then $5,000 would be taxed as ordinary income.
Next, to find the capital gains tax portion, subtract the total premium plus portion taxable as ordinary income from the amount the policy sold for. So, if the policy was sold for $40,000, then the amount taxable at the capital gains rate would be $10,000 ($40,000-$25,000-$5,000).
Are There Ways To Avoid Paying a Tax on Life Insurance?
Not including the death benefit, the beneficiary will usually have to pay taxes on any income earned that exceeds the policy basis. However, there are ways to avoid estate-related taxes and that usually starts with designating your spouse as the beneficiary.
However, estate taxes may still apply if the value of your assets exceeds a certain amount set by your state. If you suspect your life insurance payout will be subject to estate administration taxes, talk to an attorney about setting up an irrevocable life insurance trust (ILIT), which can help you avoid such taxes.
Is Life Insurance Tax-Deductible?
In most cases, life insurance premiums are not tax-deductible. The IRS classifies these payments as personal expenses similar to paying for rent and utilities. However, there are some exceptions and these will usually involve being a business owner or donating to a charity.
Business owners can deduct life insurance premiums paid for their employees as well as themselves, as long as the business owner or the company is not the policy's beneficiary.
Another opportunity to qualify for a tax deduction on life insurance premiums is to transfer ownership of the policy to a qualified charity. Despite the charity being the policy owner and beneficiary, the premiums would still be paid by you. If premiums are paid this way, they may be eligible for a tax deduction.