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Is Life Insurance Taxable?

Life insurance is generally not taxable, but there are a few exceptions. For example, any interest you earn from life insurance payouts is taxable and should be reported. Another instance is when a policy's beneficiary is a high-value estate that triggers estate taxes.

Here's what you should know about life insurance and taxes to avoid any surprises.

Are Life Insurance Payouts Taxable?

One of the best things about life insurance is that it is not taxable in most cases. Your beneficiaries don't typically have to pay income taxes on life insurance payouts. However, you may be taxed on any death benefit that exceeds your policy basis — the total sum of your premium payments minus dividends and interest earned.

Generally, your insurance policy may be taxable in the following scenarios:

Scenario

When It's Taxable

The insurer pays the beneficiary in installments.

If the beneficiary elects to receive death benefits in installments instead of a single lump-sum payment, they will need to pay any interest that accumulates on the balance.

The payout becomes a part of your estate.

If your estate is a beneficiary and its total taxable value is greater than $12.06 million (in 2022), your beneficiaries will need to pay an estate tax.

The policyholder takes out money from the cash value without repaying it.

What's taxable is anything that exceeds the policy basis, meaning your insurance premiums and investment gains. If the cash value of your policy exceeds the cost value or amount you paid in premiums, the difference is taxable.

The policyholder takes out a loan against the policy.

If the policy doesn't lapse, you won't be taxed.

The policyholder cash surrenders the policy.

Interest earned, dividends and capital gains are taxable, and there may be additional taxes if there are outstanding balances.

The policyholder sells their life insurance policy to a life insurance settlement company.

Interest earned, dividends and capital gains are taxable, and additional capital gains tax for proceeds above the cash value.

You may be taxed on any death benefit that exceeds your policy basis.

Different Types of Permanent Life Insurance

Permanent life insurance is a blanket term for life insurance policies that never expire. Most permanent life insurance policies combine death benefits with cash value.

Policy Type

Description

Taxable?

Whole life insurance

You pay fixed premium payments for the policy's life. You get a guaranteed death benefit and fixed cash value growth while your policy is active.

The death benefit is not taxable.

However, any interest you earn is taxable and you should report it. Withdrawals are taxable if they exceed the policy basis.

Universal life insurance

Flexible premiums and death benefits. The cash value is not fixed and is subject to change. Its growth is based on market interest rates.

The death benefit is not taxable.

However, any interest you receive is taxable and you should report it. Withdrawals are taxable if they exceed the policy basis.

Variable life insurance

Cash value grows based on investments offered by your life insurance company. There is a risk if the investments do not perform well and decrease the value of your death benefit.

The death benefit is not taxable.

However, your beneficiaries may be subject to federal income tax if you withdraw money from your policy and do not pay it back in full before the time of your death.

Variable universal life insurance

Premiums are flexible and can be adjusted and death benefits. Cash value grows with the investments you make.

The death benefit is not taxable.

Withdrawals are taxable if they exceed the policy basis.

Indexed universal life insurance

Like Universal, Indexed is flexible and allows you to change your premium payments. The cash value growth is tied to a stock index.

The death benefit is not taxable.

Withdrawals are taxable if they exceed the policy basis.

Is the Cash Value in Permanent Life Insurance Policies Taxable?

When your permanent life insurance policy builds cash value over time, tapping into that equity is not always tax-free. While rare, it's possible to face hefty taxes in certain situations.

Interest earned, dividends and capital gains  are taxable.

Taking Out a Loan Against the Cash Value

While cash value loans are not taxable, you would have to pay taxes if you do not repay your loan or let your policy lapse. If your insurer decides to cancel your policy, they will use the cash value to repay your loan, and you will owe taxes on any amount that exceeds the loan amount. If you die before the loan is paid off, any amount owed would be taken from what your beneficiaries would receive.

Selling the Life Insurance Policy

The IRS will look for two types of taxes when selling your policy:

  • Capital gains tax: Any financial growth beyond the policy's cash value

  • Income tax: Any financial growth beyond the policy basis (e.g., dividends and earned interest)

If you want to avoid paying capital gains tax, you may instead want to use section 1035 of the tax code to trade an older policy with a newer one with appreciable features.

Surrendering the Policy

Surrendering your death benefits, or canceling your life insurance policy, results in the insurer paying out the policy's cash value (minus surrender fees). Any cash value beyond the policy basis (e.g., dividends and earned interest) would be taxable. While you're able to receive the built-up equity early, your beneficiaries will not receive a payout if you die.

Can you cash out life insurance before death?

In some cases, you can cash out your life insurance policy while you're still alive. However, it may depend on the type of policy you have and if it is eligible. You have several options for cashing out your life insurance policy while you are still alive.

You can take out a loan from the accumulated cash value on your policy — these loans charge interest that can directly impact the death benefit if you don't pay your loan back in full before you die. You can also withdraw money from the cash value of your policy without accruing interest charges. Or, you can cancel your policy for the accumulated cash value and pay income tax if the payout exceeds the premiums you've paid over the policy's life.

What Happens When the Cash Value Exceeds Death Benefit?

With permanent life insurance, your heirs will commonly receive the death benefit from your policy. If you plan on building up a large cash value, you may want to go over your policy and understand your terms and options. Some permanent life insurance policies allow your beneficiary to receive the cash value; however, you have to request this policy specifically.

In a normal life insurance policy, if your cash value exceeds the death benefit, you can request to increase the death benefit by completely transferring the cash value over to the face value of your policy. This is more money your beneficiaries could receive rather than letting it go to the insurance company. You can also use the cash value to pay off your premiums.

While cash value loans are not taxable, you would have to pay taxes if you do not repay your loan or let your policy lapse.

The best way to enjoy cash value growth is by using it while you are alive. You can do this by taking out a loan against your cash value or withdrawing it from your policy. Once you have died, your heirs will no longer be able to access it unless you have a special rider. If you borrowed from the cash value, you would pay interest on the loan. If the loan is not repaid before you die, the insurer will deduct what you owe from the death benefit. Any other cash value withdrawals will also get taxed at your normal income tax rate.

Unless you have purchased a specific rider that allows your beneficiaries to receive both the cash value and death benefits, the insurer will typically absorb the cash value after you die, and your beneficiary will receive the death benefit — therefore you would not be taxed if the cash value exceeded the death benefit.

Is life insurance with a cash value worth it?

A permanent life insurance policy builds cash value and often has much higher premiums than term life insurance. Deciding if it's worth it could depend on the level of risk you are willing to take and the flexibility you have. Permanent life insurance is often more complex than term life. It may be recommended for high-income earners who want an extra option for tax-deferred savings and who may have maxed out their retirement account contributions, such as their 401(k)s and IRAs, and who can commit to a long-term policy.

Permanent insurance policies are recommended if:

  • You can easily afford a lifelong commitment to costly premiums

  • Want to ensure that your heirs are protected

  • Have a lifelong dependent that you can continue taking care of after you are gone

  • Want to build cash value

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How Do You Avoid Paying Taxes on Life Insurance?

One of the greatest benefits of life insurance is that death benefits are not usually taxed. There are instances where payouts may be taxed, however. Here are some ways you can avoid it:

Lump-Sum Payouts

One way you can avoid paying taxes is to have your insurer distribute the payout after your death in a lump sum. If the insurer holds on to the payout, the payout could earn interest that includes both the principal and interest earned. While the principal is tax-free, the interest is taxable as income tax. You can reduce or avoid this by not electing installment payouts.

Transfer Ownership

You can also avoid taxes by transferring ownership of the policy. The policy proceeds may be subject to federal estate taxes if you are in control of the policy.

Establish an Irrevocable Life Insurance Trust (ILIT)

If your estate is listed as a beneficiary in your permanent life insurance policy, setting up an ILIT can help you avoid payouts being axed as part of your estate. This allows you to transfer ownership to the trust, so you are no longer the trustee. You would add an ILIT to your own life insurance policy while you are still living. When you die, your death benefits are deposited into the ILIT and then dispersed to your trust's beneficiaries.

Surrendering your death benefits, or canceling your life insurance policy, results in taxes if there is a cash value beyond the policy basis.

FAQs

Is life insurance tax-deductible?

Typically, you cannot deduct your life insurance premiums when filing your taxes. The IRS considers life insurance premiums a personal expense, and it is not a requirement by your state and federal government, so you would not be able to deduct it from your taxes. If you die while your policy is active, your beneficiaries can receive a tax-free cash payment to replace your income.

When is cash value taxable?

If you own a permanent life insurance policy with cash value, you can borrow against the built-up equity in the form of a loan. This cash would not be taxable if you borrow below the policy basis (the total sum of your premium payments, minus dividends and interest). Any amount over the policy basis is taxable.

Are life insurance dividends taxable?

Typically, you won't pay dividends on life insurance since the IRS considers them refunds of your premium. However, if the insurer puts the dividends in an interest-earning investment account, you would be subject to income tax on any gains.

Is group term life insurance taxable?

If your policy is worth less than $50,000, the premiums are not taxable. If the coverage goes over $50,000, and your employer pays some of the cost, the premiums are considered income tax. Only any portion that is more than $50,000 is taxed. If you purchased and paid for the premiums yourself through your work, then you will not owe income tax.

Make Sure You Pick the Right Life Insurance Policy

Typically, the beneficiary of a life insurance policy receives a death benefit after the policyholder dies. Any amount they receive is not considered taxable income, meaning the beneficiary does not have to pay taxes on it. However, there are a few exceptions.

Life insurance can protect your spouse and children from the loss of your income and financial losses if something happens to you. It can help them with final costs, medical bills, a mortgage, tuition expenses and sometimes establish financial security. Depending on your needs, cash value permanent life insurance may be a good investment.

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