When you’ve lost a loved one, money should be the last thing on your mind.

If you wanted to alleviate those concerns, you might have purchased life insurance.

But now, you have questions about taxes and how it all works.

You might be asking yourself, is life insurance taxable? Do beneficiaries pay taxes on life insurance policies?

Generally, life insurance payouts are not taxable. However, under some circumstances, they might be. Let’s break it down.

Is Life Insurance Taxable?

Is Life Insurance Taxable? What Does The Tax Code Say? Usually, life insurance payments are tax-free.  You’ve paid a premium, maybe over the years, or maybe all at once.

You paid the premiums with money already taxed in your income taxes. That’s why, under most circumstances, a life insurance payout isn’t taxable.

The good news about life insurance is that there are numerous circumstances where it is not taxable.

Most often, it isn’t taxable at all. This feature is part of its appeal; you can leave money for your family and loved ones with the assurance that it will go to them, not taxes.

What Does the Tax Code Say About Life Insurance?

The tax code generally excludes life insurance death benefit proceeds from the gross income of whoever receives them, under U.S. Code, Title 26, Sec 101.

There are several sections of the tax code that are important to know. First, if you have a permanent life insurance policy you want to make sure that it’s a life insurance contract, not a modified endowment contract.

U.S. Code, Title 26, Sec 7702 defines “what is life insurance” and the rules around an “insurance contract.” The other sections of the tax code that you’ll want to consider are the U.S. Code, Title 26, Sec 101, subsections (a) and (g).

This portion of the tax code states that “proceeds from a life insurance policy payable by reason of death” are generally excluded from the gross income of the person receiving the benefit.

Different Types of Taxes

There are four main types of taxes. It’s important to remember that each state may have its own tax rules, in addition to federal tax guidelines.

Here’s an overview of the four main types of federal tax policies.

  • Income tax: Income tax is the one familiar to most people. These are taxes you pay on any money you earn.

  • Estate (or inheritance) tax: In 2020, estate taxes only apply to estates worth more than $11.58 million. The taxable amount is whatever surpasses the initial $11.58 million.

  • Gift tax: Gift tax applies to any gift that exceeds $15,000 in value (annually). With life insurance policies, this is most relevant if the (living) policyholder transfers the policy to someone else.

  • Generation-skipping transfer tax: This tax is similar to estate tax and has similar thresholds. The only distinction is that it applies to property that skips a generation. An example would be if your father bequeathed assets to your nephew, but not your sibling.

How Taxes Work on Life Insurance Death Benefits

There are several instances where there may be more nuance to the taxes on life insurance death benefits.

Selling a Life Insurance Policy

When you acquire a life insurance policy, you also acquire the right to sell that policy—meaning that you can sell the policy to another individual or a third-party.

What’s key here, for tax purposes, is that if you earn anything beyond the original price, that amount will be considered profit.

You will have to pay taxes on the earned income from the sale.

Incremental Payouts vs. Lump Sums

If your beneficiaries decide to receive incremental payouts of the life insurance policy, the premium may accrue interest.

They would have to pay taxes on the earned interest. If paid out as a lump sum, there wouldn’t be any tax cost.

Your Estate Exceeds the Estate Tax

This situation applies explicitly to proceeds above the threshold limits for estate tax. If the benefits of your policy increase your estate beyond the $11.58 million, then the benefit could be taxable.

There are several options for how to ensure your beneficiaries receive benefits with the least possible tax burden. One potential would be to create an irrevocable life insurance trust, also known as an ILIT. Another option is Crummey Power.

For both of these choices, you would want to consult with a financial advisor about your specific situation.

Cash Value Policies

A cash value policy is any permanent life insurance policy that has an investment component.

Usually, Indexed Universal Life (IUL) Insurance Rates By State In America whole life insurance policies are a good example of this. A portion of your premium goes to the insurance coverage, and a portion contributes to an investment. The cash value of the policy may increase or decrease, depending on the investments. Most policies have a minimum guaranteed interest rate.

The interest that you earn is tax-deferred, so you won’t pay taxes on it until you withdraw an amount beyond what you’ve paid. Sometimes, individuals borrow against the cash value of the policy (similar to borrowing from your IRA to purchase your first home).

When you borrow like this, it’s considered a loan. Certain tax rules apply here if your policy lapses while you still have an outstanding loan.

Group Life Insurance

Some employers provide group life insurance for their employees and subsidize a minimum amount.

If the coverage exceeds $50,000, it’s considered income and is, therefore, taxable.

Coverage beneath $50,000 isn’t income and, therefore, is exempt.

Are Life Insurance Premiums Tax-deductible?

Unfortunately, the answer to this is “no” most of the time. The only circumstance where life insurance premiums would be tax-deductible is certain very specific business expense situations.

Is Return Of Premium Life Insurance Taxable?

Although you may receive a lump sum with the return of a life insurance premium, the tax code considers it a refund.

This refund status means it is not taxable. You have already paid income tax on the life insurance premium.

Taking Action

Hopefully, you have a better sense of life insurance and when components are taxable and when they are not.

Both life insurance and taxes are complicated topics. You need an expert to provide you with the right information and correct answers to your questions to protect your financial interests.

If you need life insurance, you can get immediate quotes and coverage by clicking Compare Life Insurance Quotes Online or on any of the above buttons.