There are so many questions about what taxes one must pay on life insurance proceeds. But one that we get a lot is, do you pay taxes on life insurance payout? The subject can be a bit intimidating for a lot of people so we decided to put together a quick reference guide on how life insurance works and what tax liabilities might exist for a life insurance policy.
We'll address several areas of life insurance values as well as several different types of taxes found in the United States to which life insurance could be subject.
First, to get right to the point, in most situations, you will not have to pay income taxes on a life insurance payout or the death benefit as it is commonly known. There can certainly be situations where that is not true but those are rare. In fact, in nearly 20 years of doing this, we've never seen an instance where the life insurance payout created any sort of income tax liability.
Now, that being said, there may be some instances where a life insurance death benefit creates other types of taxes. Read on to here more specifics about all the aspects of life insurance payouts being taxable.
Is My Life Insurance Death Benefit Taxable?
That one question that dominates the field of questions regarding life insurance payout taxability concerns the taxability of the death benefit. The short answer that applies to over 90% of situations is no. The more complicated and accurate answer is that it depends.
Income Taxability of Life Insurance Death Benefit
Life insurance death benefits are not subject to income taxes. Neither the beneficiary, nor the policy owner has any income tax liability from the claim payment on a life insurance policy. The purpose of this special tax treatment for life insurance comes from a simple idea.
Keep in mind, the principle idea of life insurance is to protect the financial stability of families in one of their darkest hours. And as such, the grieving family should not be burdened with an additional income tax liability as a result of receiving a payout from a life insurance policy.
But you should know that any interest earned on the death benefit absolutely creates an income tax liability, which could be trivial or substantial depending on the size of the death benefit and the amount of earnings achieved on the death benefit.
Here's what we mean…
Example 1 – Interest Earned on Proceeds
Jane is the beneficiary of her Husband Jeff's life insurance policy with a face amount of $2 million. Jeff passes away and Jane receives $2 million in death benefit proceeds and chooses to leave all $2 million in the insurance company's “retained earnings account.”
Jane does not incur any income tax liability for the $2 million death benefit, but over the next 12 months she does earn $60,000 in interest from the retained earnings account. The insurance company will issue a 1099 to Jane showing $60,000 in interest income, which Jane must file with her income taxes. The $60,000 interest payment will increase Jane's gross earnings for the year by $60,000, which is all subject to income tax.
Sometimes the interest earned on a death benefit is due to regulatory required interest payments insurance companies must pay beneficiaries. This most commonly comes up whenever an insurer's time to process a death claim takes long enough to incur an interest payment–generally any time longer than 30 days.
Example 2 – Interest Owed for Payment Processing Time
Joe is the beneficiary of his dad Harold's life insurance policy in the amount of $250,000. Harold passes away and Joe files the claim with the life insurer. The policy was issued recently and the insurer chooses to investigate the claim to ensure no foul play occurred.
Three months later, the insurer wraps up its investigation finding no reason to void the contract. Joe received the $250,000 death benefit and an additional $2,500 in interest due to him from interest accumulated while the insurer held the death benefit.
Joe will incur no income tax liability from the $250,000 death benefit, but he will receive a 1099 for the $2,500 interest payment, which he must file with his taxes and he will incur an income tax liability for the $2,500 interest payment.
There are also times when interest paid on a death benefit might be part of an available feature of the life insurance contract. The most common circumstance is a settlement option that is not a single lump sum payment.
Example 3 – Interest Earned by Settlement Option
Phyllis is the beneficiary of a $1 million life insurance policy insuring her late husband John. Instead of receiving the entire $1 million immediately, Phyllis chooses a settlement option that will pay her $5,000 per month for the next 20 years.
The $1 million death benefit will create no income tax liability to Phyllis. The interest that the insurance company pays on the settlement option will create an income tax liability. At the end of each year, Phyllis will receive a 1099 from the insurance company that reports the interest paid by the insurer to Phyllis as part of the settlement option. Phyllis will need to file this 1099 with her taxes to claim the interest income.
Estate and Gift Taxes Due on Life Insurance Death Benefit
Life insurance proceeds are subject to Estate and/or Gift Taxes–where applicable. For purposes of U.S. Federal Estate and Gift Taxes, life insurance policies includable in the calculation of the deceased's gross estate. The same is generally true of states that have an estate tax.
Example 4 – Life Insurance Owned by Deceased
Gloria recently passed away. Her husband died before her. At the time of her death, Gloria owned a $3 million life insurance policy. Gloria's gross estate includes all assets that she owned plus the $3 million death benefit payable to her named beneficiaries.
An exception to this rule concerning life insurance and the gross estate exists for life insurance that the deceased neither owned nor had controlling interest, but was the insured. In such circumstances, the death benefit proceeds are no included in the deceased's gross estate. This fact is the core of many estate plans are set up to use life insurance as a means to pay estate taxes.
Example 5 – Irrevocable Life Insurance Trust
Brent and Cindy own a successful freight company and as a result the couple amassed a significant net worth. In order to pay the estate taxes they anticipate being due upon their passing away, the two establish irrevocable trusts and gift money to the trusts that the trustee uses to purchase life insurance policies insuring Brent and Cindy.
Because Brent and Cindy have no ownership or control over the trust or its assets (i.e. the life insurance) and because the trust sends notices to trust beneficiaries notifying them of their rights to remove funds in the trust, any death benefit proceeds paid by the life insurance policies owned by the trusts are not included in Brent or Cindy's taxable estate.
However, an important rule must be met in order to avoid gift tax implications for beneficiaries. A life insurance policy cannot have a different insured, owner, and beneficiary. If this circumstance exists, the death benefit proceeds of the life insurance policy carry a gift tax liability incurred by the beneficiary. We generally call this circumstance a Goodman Triangle.
Example 6 – Goodman Triangle
Kim owns a life insurance policy insuring her brother Jim and names Jim's adult daughter Meagan as beneficiary. Jim passes away and now the death benefit paid to Meagan carries a gift tax liability. That's because Kim was the owner, Jim was the insured and Meagan is the beneficiary.
Income Taxes and Life Insurance Cash Values
Some, but not all, life insurance policies have a cash surrender value that builds up over time due to the payment of premiums to the policy.
These cash values can be withdrawn from the policy or pledged as collateral to acquire a loan from the insurance company. In some circumstances, taking this money out of the policy can create an income tax liability to the policy owner and in other circumstances it does not.
First-in First-out Withdrawals
Life insurance enjoys an accounting principal for withdrawing money we commonly refer to as the FIFO rule, which stands for First-In First Out. This means the policy owner can withdraw the proceeds he or she contributed to the policy first and then distribute gain once he or she withdraws all contributions.
Example 7- Withdrawing Money FIFO
Mia owns a life insurance policy with a cash surrender value of $50,000. Mia's total premiums paid to date total $15,000. Mia plans to withdraw $25,000 from the policy.
Mia's tax liability on the withdrawal is $10,000. This happens because Mia will first withdraw her $15,000 contribution to the policy–i.e. the premiums she paid. Then Mia will withdraw the additional $10,000 she wants from the earnings in the policy.
At the end of the calendar year, the insurance company will send Mia a 1099 showing her taxable withdrawal as $10,000
From the example above, there is no special instruction that Mia needs to send to the insurance company. The insurer will automatically take care of sorting out what portion of her withdrawal request is a recover of her contributions to the policy and what portion of gain from earnings in the policy.
Income Taxes and Loans
Distributions taken from a life insurance policy in the form of a loan do not incur an income tax liability. There is one exception to this rule and that's when the life insurance policy fails to meet the requirements of being a life insurance policy and becomes reclassified as a Modified Endowment Contract.
Example 8 – Distribution Through Policy Loan
Neil owns a life insurance policy with a $150,000 cash surrender value. Neil decides to take a loan against his policy for $30,000.
At the end of the calendar year the insurer will send Neil a 1099 that does report a distribution from his policy, but the 1099 will report that none of the distribution is taxable income to Neil.
Income Tax Consequences of Surrendering a Life Insurance Policy
Whenever a policyholder surrenders a life insurance policy that has cash value, he or she will receive details of the money the insurer owes him/her and any potential tax consequences this surrendered money might impose.
The policyholder will not incur a tax liability on values that reflect his/her contributions to the policy. The policyholder will incur tax liability on values that reflect earnings from the policy
Example 9 – Full Surrender of Policy
Nathan recently surrendered a life insurance policy that hat $250,000 in cash surrender value. Nathan paid $100,000 in premiums during the policy's existence. Following the end of the calendar year, the insurance company sends Nathan a 1099 showing that $150,000 of the distribution he received is taxable income.
Nathan must file this 1099 and will owe taxes on the $150,000 of gain the policy created for him. And remember, his policy no longer exists as he fully surrendered the benefits of the policy.
Estate and Gift Taxes Due on Life Insurance Cash Values
When a life insurance policy builds cash value, the Federal Government treats that value like any other asset with respect to the gift tax. Anytime a policyholder chooses to transfer ownership of his or her policy to another person, the cash value of the policy is a gift in the amount of the net cash surrender value of the policy. Of course, the annual gift tax exemption amount applies.
Example 10 – Gifting a Life Insurance Policy
Paul owns a life insurance policy that has a net cash surrender value of $45,000. He choose to transfer ownership of the policy to his son Lance. Upon transferring the policy, Paul will have made a gift to Lance in the amount of the cash surrender value.
The $45,000 gift comes with a $30,000 gift tax liability since Paul can deduct the annual exemption of $15,000 from the gross transfer amount.
Paul will need to file information of the gift with his taxes for the current calendar year using IRS form 709.
When Gifting Could Minimize Tax Burden
As we covered above in the “Estate Gift Tax and Death Benefit” section, life insurance proceeds from a policy owned by an individual are included in his or her gross estate calculation. If someone relinquishes ownership in a life insurance policy, the death benefit might be removed from the gross estate calculation. There is a three year look back period that must pass or else the IRS will disallow the gift.
Example 11 – Gifting Life Insurance to Minimize Estate
MaryJane recently purchased a $3 million life insurance policy, it currently has $50,000 in net cash surrender value. She has a current net worth that places her about $1 million below the estate tax exemption amount. She'd prefer not to have her life insurance proceeds included in her gross estate because they will become taxable under the estate tax.
MaryJane chooses to gift the policy to her son Tyler as a means to remove the death benefit from her gross estate. Provided MaryJane lives for the next three years she will have made a $35,000 gift to Tyler, which will incur gift tax liability, but she can plan to use remaining credits from the lifetime exemption for the gift.
Taxes and Employer Provided Life Insurance
Many employees enjoy varying degree of life insurance coverage through their employer. This is a form of life insurance known as group life insurance. Current tax law provides for all employees to incur zero income tax liability consideration for group life insurance coverage up to $50,000.
Example 12 – Group Life Insurance Coverage Under $50,000
Juanita works as a secretary at a local shipping company and has coverage under a group life insurance plan that pays $25,000 upon Juanita's death provided she still works at the company. Juanita does not pay any premiums out of her pocket for this coverage and her beneficiary(ies) would have no income tax liability for the death benefit if she passed away.
For coverage amounts exceeding $50,000 the covered persons receive imputed income for the cost of providing the death benefit amount in excess of $50,000.
Example 13 – Group Life Insurance Coverage Over $50,000
Shanda is an Engineer who is covered by a group life insurance plan that will pay $400,000 to a named beneficiary if she dies while covered under the plan. Each year Shanda received a w-2 from her employer that reports imputed income for the cost of the $350,000 (because it's in excess of the 50k limit) in life insurance coverage she has under the plan.
Shanda will report the imputed income as part of her gross earnings for the year and pay income taxes on it.
If the covered person under the plan did not recognize and pay taxes on the imputed income in the case of group life insurance coverage, then the amount in excess of $50,000 would be income taxable to the beneficiary(ies) which is not ideal.
When someone purchases additional coverage (with after-tax money) offered through a group life insurance plan, the death benefit tax treatment is the same as an individually bought and owned life insurance policy. This means that the death benefit is not income taxable to the beneficiary.
Taxes and Business Owned Life Insurance
Many businesses choose to use life insurance as a funding mechanism for various fringe employee benefits they may offer select employees.
Example 14 – Supplemental Retirement for Executive
Judy is a key executive at her company and the board wants to ensure that she remains with the company until she's ready to retire. The board establishes a retirement bonus benefit that will pay Judy $50,000 per year upon retiring at age 65 until she dies, however Judy will only receive this benefit if she remains with the company until she's 65. This is an example of “golden handcuffs”.
To make sure that this plan has adequate funds to afford the payments to Judy in the future, the company purchases a cash value type of life insurance policy with Judy as the insured.
The premiums paid by the company to the plan will create a tax liability to Judy, but the company could choose to provide her with additional compensation to cover the additional tax liability. When Judy retires, she will not owe taxes on the $50,000 benefit paid to her by the company.
Judy's employer will plan to use the death benefit of the life insurance policy to recoup its expenses for providing this benefit upon Judy's death. The death benefit is tax free to the company.
In addition businesses may choose to purchase life insurance on key employees whose existence within the company is crucial for continued operations.
Example 15 – Key Employees
Dan, the VP of sales at his company plays a crucial role in the acquisition of new business. The company recognizes that if Dan were to pass away, it would take them some time to replace him and would likely result in lost revenues from a decline in sales.
The company chooses to purchase life insurance with Dan as the insured on the policy so if Dan passes away, the company will have additional cash available to prevent business interruptions while it searches for Dan's replacement.
Business partners also often purchase life insurance on each other in order to liquidate ownership interest in a company should one of the partners die.
Example 16 – Business Partners
Ben and Larry own several successful car dealerships and run a management company to oversee dealership operations. The two realize that neither has the cash on hand to buy out the other's interest and the cash on hand at the company would be severely diminished if they chose to use it for this purpose, potentially crippling the company.
Ben and Larry decide to purchase life insurance on each other as part of a buy/sell agreement they put in place so that they have the funds necessary to buy out the other's interest should one of them pass away. The life insurance proceeds received will be tax free enabling them to use all of those funds for buying out the other's interest in the company.
Generally speaking all forms of life insurance ownership by a business do not incur an income tax liability.
This statement only holds true if the business paid the premiums with after-tax money. Many times business owners like the idea of using the life insurance premiums as a deductible expense for the company but this is not ideal. If the premiums are paid pre-tax, there are undesirable tax consequences.
Example 17 – Making a Business Owned Life Insurance Death Benefit Taxable
Ray is the founder and owner of a hedge fund that owns a $5 million policy on Ray. This money will give senior management time to liquidate the fund in an orderly fashion with Ray gone.
The company has been deducting the premiums paid to the life insurance policy as a business expense. If Ray passes away while the policy is in force, the company will owe taxes on the life insurance policy proceeds.
Important Tax Disclaimer
While we've made every effort to ensure the accuracy of the above information, please note that this information is intended as general information about a complex subject. None of the above information is a substitute for personalized professional tax advice and you should always seek out of the guidance of an appropriately licensed professional to answer specific questions about any individual tax circumstance you might have regarding life insurance.