Does life insurance get taxed?

One of the main selling points of life insurance is that the proceeds are typically not taxable. There are a few situations where beneficiaries will have to pay tax — and they usually apply to permanent policies or policyholders with large estates.

When are life insurance proceeds tax-free?

Generally, your beneficiaries can dodge taxes in these situations.

Death benefit paid out to beneficiaries

Most people buy life insurance so they can leave money to their beneficiaries when they die. Fortunately, the death benefit isn’t considered taxable income, so the full payout will go to your beneficiaries. There’s one exception, and that’s when your estate is valued at more than $11.58 million — the IRS threshold for 2020. In this case, the proceeds of the policy will be counted as part of your estate and may be subject to federal estate taxes.

Cash value gains

If you choose a whole or universal life insurance policy, it builds cash value 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.

Surrender payouts

If you decide to discontinue your life insurance policy before it matures, you’re eligible to gain access to your accrued cash value minus any surrender fees. This is called a “life insurance surrender,” and 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 life insurance policies offer an accelerated death benefit rider, which allows you to access part of your death benefit while you’re alive if you’re diagnosed with a chronic or terminal illness. You can spend this death benefit early payout on anything you like, such as your medical bills, long-term care or everyday expenses. The IRS defines the 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. Policyholders with these companies are eligible to receive annual dividends on the company’s profits. 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.

Return of premium policy refunds

A return of premium (ROP) policy reimburses you for your paid premiums if you outlive the policy. Since it’s a refund — and not a payment or profit — the money you receive isn’t subject to tax.

When is life insurance taxable?

Though life insurance has many tax benefits, there are a few situations when your policy’s proceeds will be taxed.

With so much riding on your life insurance, speak with a licensed accountant if you’re still unsure about your specific policy’s tax implications.

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 is taxed. 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.

Regardless of whether your beneficiaries collect the life insurance payout by lump sum or installments, any interest earned on payouts is taxable.

Profit from surrendering a cash value policy

If you cancel a cash value life insurance policy, 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 estate is valued at $11.58 million – the IRS threshold for 2020 – or more, it will be subject to federal estate tax. This applies to life insurance payouts, too.

To avoid this tax, consider setting up an irrevocable life insurance trust (ILIT). It will stop the proceeds from your policy from being counted as part of your estate. Just keep in mind that if you transfer the policy less than three years before your death, it might still be subject to the estate tax.

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.

Generation-skipping transfer tax

Generally, life insurance payouts to your spouse and children are not taxed. But your payout could be subject to taxation if your designated beneficiary isn’t a relative.

The generation-skipping transfer tax requires taxation on direct gifts that benefit:

• 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.

Profit from life insurance settlements

If you no longer need or want your life insurance policy, you might choose to sell off 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.

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.

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Bottom line

Life insurance is a complicated coming-together of two of life’s certainties: death and taxes. In most cases, the payout from your policy won’t be taxed. But there are a few situations where your beneficiaries will have to cough up taxes — like if your estate exceeds the IRS’ threshold for that year.

With frequent changes to tax laws and the IRS revenue code, speak to a licensed accountant or adviser if you have questions about the tax implications of your policy. In the meantime, protect your loved ones by comparing life insurance companies.