Your beneficiaries can generally dodge taxes — but only in a few key situations.
Life insurance offers financial security for your loved ones when you’re no longer able to provide for them. You can personalize most policies to cover multiple unexpected circumstances, and your monthly premium payments contributing to your death benefit and the policy’s cash value.
Premium payments are not subject to tax, and your cash value defers taxes until payout. But where does that leave your actual death benefit?
There’s a lot to know about the tax implications of life insurance. Here’s what you can expect as far as taxes on your payout — and a few key situations exempted from tax-free status.
When is my life insurance payout not subject to taxes?
A main reason so many Americans opt for life insurance is because beneficiaries can generally avoid taxation on the policy’s death benefit.
Payouts to beneficiaries
Many people contribute to their life insurance policies for decades, amounting to a hefty death benefit when the policyholder dies. You likely want this money to go to your beneficiaries, not the tax man.
Fortunately, the money that’s paid out as a death benefit isn’t considered taxable income, which means the full payout as detailed in your policy goes to your spouse, children or other designated beneficiaries. Generally, spouses gain nearly unlimited exemption from estate taxes.
Cash value gains
If you choose a permanent whole or universal life insurance policy, it often comes with a cash value benefit that accumulates over time. The cash value gains are not subject to any taxation unless the policy is surrendered or transferred to another owner — a scenario referred to as a life insurance settlement.
Should you decide to cancel your life insurance policy before it matures, you’re eligible to gain access to your accrued cash value, less any surrender fees.
Called a life insurance surrender, as long as your settlement amount is less than the total you paid in premiums, your surrender payout is tax-free.
Early payout for chronic or terminal illness
Many permanent life insurance policies offer riders or add-ons that cover unexpected chronic or terminal illness. These riders generally allow for an early payout of your death benefit to cover the medical costs, long-term care and everyday expenses that come with illness.
Generally, the IRS defines payout on such riders as an “acceleration of death benefits,” protecting them from taxation.
Annual life insurance dividends
Some big-name providers like Liberty Mutual, State Farm and New York Life are mutual insurance companies, which means they’re owned in part by their policyholders. (This is as opposed to stock insurance companies, which are designed for profit to stockholders.)
Policyholders with these companies are eligible to receive annual dividends on the company’s profits. Considered a “return of premium,” these dividends are not taxable as long as your received dividend amount is not more than the sum of your premium payments in the same year.
Scenarios when life insurance is taxable
Though tax exemptions are a benefit of life insurance, you’ll find specific exemptions to tax-free status that involve interest earned, large estates and the generation-skipping transfer tax.
With so much riding on your life insurance, speak with a licensed accountant if you’re unsure how taxes relate to your specific policy.
Interest earned on payout benefits
After you die, your life insurance beneficiaries often can choose to receive your policy’s death benefit as a lump sum or in installments over time. If they choose installments, the policy’s insurer holds the death benefit, which may accrue interest, depending on the account it’s held in.
In this case, the benefit’s principal avoids taxation, but any interest earned on it does not. So if your $250,000 life insurance benefit gains $25,000 in interest between time of your death and payout, your beneficiaries would likely owe taxes on the accrued $25,000.
Profit from surrendering a cash value policy
If you cancel before maturity a life insurance policy that includes a cash value, that cash surrender value is likely subject to taxation if it’s higher than the sum of your premium payments.
Say you’ve paid $8,000 in premiums annually over the 15 years you’ve owned your policy — a total of $120,000 over that time — allowing your policy’s cash value to grow to $150,000. If you cancel your policy, you’ll likely owe taxes on the $30,000 you’ve earned.
Unpaid loans against your policy
After a stated period of time, many permanent life insurance providers allow you to borrow from any cash value benefit you’ve accrued. Like most loans, you’re required to repay that loan with interest.
If you allow a policy to lapse or you cancel it outright before you’ve repaid your loan, you’ll owe taxes on the outstanding balance beyond what you paid into the policy.
Estate taxes on life insurance payouts
If your policy does not include a beneficiary, among other specific situations, your death benefit payout could be added to your overall estate.
If the value of your estate exceeds your state’s limit, your estate could be subject to an estate tax — including your death benefit.
Note that the IRS offers an unlimited marital deduction that allows you to transfer unlimited assets to your spouse, free of any estate or gift taxes.
What is the unlimited marital deduction?
The unlimited marital deduction is a provision in the federal Estate and Gift Tax Law that allows you to pass assets totaling any amount to your spouse during your lifetime or after your death as part of your will or trusts — free from both estate and gift taxes.
Eligibility requires both you and your spouse to be US citizens, however.
Generation-skipping transfer tax
Generally, life insurance payouts to your spouse and children are not taxed. But what if your designated beneficiary isn’t a relative? In that case, your payout could be subject to taxation.
The generation-skipping transfer tax requires taxation on direct gifts that benefit beneficiaries falling into categories that include:
- Beneficiaries you’re not related to and who are more than 37.5 years younger than you.
- Beneficiaries you are related to but are one generation younger than you, including grandchildren.
The IRS imposes this tax if the transfer isn’t subject to a gift or estate tax at each generation level.
Also, who the IRS considers a relative is broad, sometimes allowing for domestic partners who’ve lived in your household for an extended period of time.
Talk with a tax adviser or professional if you have any questions.
Profit from life insurance settlements
If you no longer need or want your life insurance policy, you might choose to sell your policy to someone else for a life insurance settlement. In a life insurance settlement, a buyer takes over your premium payments for the benefit of receiving the policy’s full payout after you die.
The amount of your settlement is decided by you and the buyer, but any profit you make on your settlement may be taxable. The specifics of the tax implications are unclear, so you’ll want to speak with an accountant or financial adviser when considering this option.
Failure to pass a cash value accumulation test
A cash value accumulation test (CVAT) is used to determine the merits of a life insurance policy. In simple terms, the test analyzes the death benefit against the policy’s cash value. If the cash value is too high compared to the death benefit, the IRS generally requires the provider to increase the death benefit in order to comply with the IRS’s tax revenue code.
If your life insurance policy fails the CVAT, the IRS may consider it an investment subject to income tax.
Life insurance is a complicated coming together of two of life’s certainties, as the saying goes: death and taxes.
With recent tax laws and consistent tweaks to the IRS revenue code, it’s difficult to know how they relate to your future policy payouts.
Talk with a licensed accountant or adviser if you have any tax questions related to your life insurance for advice tailored to your specific financial situation.