Life insurance has many benefits. It’s typically used to leave money to heirs, supplement income during retirement, or financially support your loved ones if you were to unexpectedly pass away.
When you purchase life insurance, you designate a beneficiary who receives the funds from your life insurance policy (called the death benefit) after your death. The money can be used for any purpose, whether it’s your funeral expenses or your child’s college tuition.
Because the death benefit provides supplementary income, it begs the question—is life insurance taxable? The short answer is, no. Life insurance is usually not taxable. However, there are a few situations when you or your beneficiaries may have to pay taxes on the money.
When Is Life Insurance Not Taxable?
Generally speaking, you don’t need to worry about paying taxes on life insurance. It’s very rare that the proceeds from your life insurance policy will be subject to federal or state taxes. Here are some of the most common situations when life insurance will not be taxed.
When your beneficiaries collect the death benefit
When you pass away, the designated beneficiary will get the money from your death benefit. There are a few different ways they can collect the money—in one lump sum, in equal increments, or in random amounts at an interval of their choosing.
The money from your life insurance death benefit is never taxed. That means your beneficiaries can use the money however they want, and they will not pay taxes on it. However, they do have to pay sales tax on the money if and when they spend it, as with any type of income.
When your cash value grows
All permanent life insurance policies have a cash value component. You can think of it as a savings account. When you pay your premium, a portion of the money goes into your cash value, and depending on the type of policy you have, it gets invested and grows with interest.
As the cash value builds, you aren’t required to pay taxes on the gains. If your beneficiaries receive the cash value after you pass away, they will also not pay taxes. However, keep in mind that in most cases, unused cash value goes back to your insurance company.
When you surrender your life insurance policy
In the event that you cancel your life insurance policy, formally called surrendering, you are not required to pay taxes on the money. Keep in mind that this only applies to a permanent life insurance policy that builds cash value.
If your cash value has grown, the insurance company will write you a check for the funds when you cancel your policy. Even if the cash value has accumulated, it’s unlikely that you will be taxed on the money. The only exception is if your cash value balance is greater than the amount you contributed.
When you use an accelerated death benefits rider
Many life insurance policies come with a built-in accelerated death benefit rider. This is a provision that allows you to use money from your death benefit while you are still living if you get diagnosed with a qualifying terminal or critical illness and only have one or two years to live.
If you use your accelerated death benefits, you won’t be required to pay money on the amount you withdraw. The reason why accelerated death benefits are not taxed is that you essentially become your own beneficiary, overriding anyone else who could claim the money after your death.
When you borrow from your life insurance policy
One of the benefits of having a permanent life insurance policy is that you can borrow some of the money from your cash value and repay it. It works very similarly to a personal loan. If you borrow from your life insurance policy, the loan money will not be taxed.
However, it’s important to keep in mind that if you borrow money from your policy, you must repay the funds. If you don’t, the borrowed amount will be subtracted from your death benefit, which lessens the amount of money your loved ones will get after you pass away.
When Is Life Insurance Taxable?
Although life insurance is rarely taxable, there are a handful of instances where you or your beneficiaries may have to pay taxes. Here are a few scenarios.
When you sell your life insurance policy
If you no longer need life insurance, one option is to sell your policy. Typically, this involves an investor purchasing your policy, naming themselves as the policy owner, then transferring the policy to someone who needs money, like a terminally ill person who can’t get insurance for themselves.
In some cases, selling your life insurance policy is not a taxable event. However, you will pay taxes if the amount you receive from the sale is greater than the premiums you paid over the lifetime of the policy.
When you are a skip person on the policy
Most life insurance policies involve two individuals—the policyholder and the beneficiary. If there is a third person on the policy, notably a “skip person,” it’s possible that they will have to pay taxes on the life insurance proceeds they get.
For example, imagine that your mother purchased a life insurance policy for her father, and named you, his grandchild, as the beneficiary. When your grandfather passes away, you would have to pay taxes on the death benefit, technically called a generation-skipping transfer tax (GSTT).
On the other hand, if your mother had named herself as the policy beneficiary, she would not have to pay taxes because it didn’t “skip” a generation.
When your policy is part of a taxable estate
Some life insurance policies are part of an estate. That means when the policyholder dies, their death benefit goes to their estate, rather than a single person. Every part of an estate, which includes things like investments, real estate, savings, debts, and vehicles, is subject to state and federal taxes.
One thing to know about estates and life insurance is that taxes are only required if the estate is above a certain valuation. In 2021, the federal estate tax applies for estates worth $11.7 million or more. Some states also charge estate tax, but not all.
Ways to avoid paying taxes on life insurance
Most people don’t have to worry about paying taxes on life insurance funds. However, there are a few ways you can avoid taxes, especially if you’re facing an estate tax.
First, consider transferring the ownership of your policy to work around the federal estate tax. To do this, call your insurance company and name another person or entity as the policy owner. The new owner will take over the premiums, and you will avoid the taxes.
Another option is to set up an irrevocable life insurance trust (ILIT). You allow someone else to take over ownership of the policy, and they become responsible for managing and distributing the death benefit when you pass away. With an ILIT, your life insurance policy is held in a trust and doesn’t get added to your estate.
Although you can escape life insurance taxes, you must take action while you’re still living. It’s unlikely that after you pass away, your beneficiaries will be able to take steps to avoid taxes.
Bottom line
In most cases, life insurance is not taxable, whether your beneficiaries collect the money after your death, or if you choose to use living benefits. The most common reason why life insurance funds are taxed is when the money becomes part of your estate. Fortunately, there are ways to avoid life insurance taxes, which ensures your loved ones get to keep the full amount of money they are entitled to.