Is Life Insurance Taxable?

It's important to understand the tax treatment of life insurance — for both the premiums you pay and the proceeds your loved ones collect.

A life insurance policy can pay out tens of thousands to hundreds of thousands of dollars. Typically when somebody collects that amount of money would have to be concerned with a hefty tax bill. But that’s usually not the case with a life insurance death benefit.

Are life insurance proceeds taxable?

Life insurance payouts are generally not taxable.

If your beneficiaries receive a one-time payout of the policy’s death benefit, they will not have to report the proceeds as income when they file their taxes. Your beneficiaries will not receive a 1099 for life insurance proceeds.

In addition to the traditional payout, there are other life insurance scenarios that are not taxable. These include:

  • A return of premium policy. This is a type of policy in which the premiums you paid over the life of the policy are returned to you once the policy expires. Since you are essentially receiving a refund for your policy payments, there are no taxes assessed on the payment.
  • Dividends from a whole life policy. Many whole life insurance policies payout dividends that represent a portion of the insurance company’s profits paid to policyholders. As long as dividends don’t exceed the amount of premium you pay, the dividends are not taxable.
  • Accelerated death benefit. With an accelerated death benefit, your policy can provide for you before you die in the event you become terminally or chronically ill. An accelerated death benefit is treated the same as a regular death benefit and is not considered taxable income.

When life insurance proceeds are taxable

There are, however, scenarios in which life insurance proceeds may incur a tax bill.

You have supplemental group life insurance paid by your employer

Some employers offer group life insurance as a workplace benefit. Some even pay some or all of the cost of coverage.

If your employer pays the full premium for $50,000 in coverage or less, there is no taxation on the death benefit. The IRS considers this amount part of your regular compensation.

However, any coverage over $50,000 is treated as income and the death benefit will be taxed.

The insurer issues the death benefit in installments

If the beneficiary receives the death benefit in installments, there may be taxes owed. That’s because the insurer will hold the principal amount in an interest-bearing account until the death benefit is fully paid out. Although the original death benefit is tax-free, the interest that accumulates is subject to income tax.

There are three parties involved with the policy

Typically, the owner of the policy is also the insured, so that the same person is paying the premium and having their life insured. In this scenario, the beneficiary(s) receive the death benefit tax-free.

However, there are scenarios where one party is the insured life of the policy, a second party owns and pays the policy premiums, and a third party is the beneficiary. In this scenario, the IRS considers the death benefit a gift from the policy owner to the beneficiary.

You surrender a policy with cash value

If you purchase whole life or universal life insurance, your coverage will remain active as long as you pay the required premiums. In addition, your policy will build cash value beyond what is needed to support your coverage. This cash value earns interest.

When you surrender a cash value policy, you cancel the coverage. The insurer will pay you the cash value accumulated in your policy, minus any fees. Any portion of that cash value payout that exceeds the amount you paid in premium is considered income and is therefore taxable.

For example, if you surrendered a policy for which you paid $100,000 in premiums and received $120,000 in cash value, you would have $20,000 in taxable income.

You sell your policy

People who want a payout now can sell their life insurance policy to another party. This is called a life settlement. It’s done in situations where a policyholder can receive more money from selling the policy than by surrendering it.

In a life settlement, the buyer of the policy becomes the new policy owner and takes over paying the premiums. When you die, the new owner receives the death benefit. The goal of this settlement for the buyer is to receive a death benefit that is more than what they bought the policy for.

If you sell your policy, you may owe income tax on proceeds that exceed what you pay in premiums. In addition, you may owe capital gains taxes on proceeds that exceed the policy’s cash value.

The death benefit becomes part of your estate

If the value of your total estate qualifies for federal estate taxes — $11.7 million in 2021 — the IRS will include your life insurance policy payout in the value. This means the death benefit adds to your overall estate, which will increase the total amount of estate tax owed.

If you may be in this situation, you should talk to a tax professional about the implications. You may be able to transfer policy ownership before you die to another person or entity, such as a trust.

You take out a loan from your policy’s cash value

Depending on the company that issued your policy, you may be able to borrow up to 90 percent of the policy’s cash value at any time. When you withdraw money from a life insurance policy, it’s considered a policy loan, even if you don’t intend to repay it. And because it’s a loan, the withdrawal is not considered taxable income.

For tax purposes, borrowing money from a life insurance policy is no different than a student loan, a home equity loan, or a car loan. Since the intention is to repay the money with interest, the IRS does not consider a life insurance policy loan as income.

Depending on the provisions of your contract, you can often take as long as you wish to pay back the policy loan. You can even choose not to repay the loan and accept a lower death benefit.

Many people, in fact, buy life insurance policies in their 40s and 50s so that it builds up enough cash value that they can use to supplement their retirement income. Basically, each withdrawal from the policy for retirement income is a policy loan, which means it’s tax-free income. Those loans are generally not repaid, and whatever is left in the policy after the owner(s) passes away is the death benefit received by the beneficiaries.

Where you may end up with a tax obligation is if the insurance company has to cancel the policy.

This can occur if you borrow too much. As with other types of loans, a life insurance policy loan charges interest. If the amount you borrow accrues enough interest that the amount you owe exceeds the policy’s cash value, the insurance company will require you to repay the loan. If you are unable, the insurer cancels the policy.

The tax bill comes because you were loaned money that you are no longer repaying. You will tax on the amount of the unpaid loan that exceeds the amount of premium you paid. For example, if you had a $25,000 policy loan balance and paid $20,000 in premiums when the policy was canceled, you would owe taxes on the $5,000 difference.

You overpay premiums on a permanent, cash-value policy

With cash value life insurance, the IRS limits how much you can pay in premium. That’s because life insurance cash values grow tax-deferred and policy death benefits are typically tax-free. Without limits to how much premium is paid into a policy, people could use life insurance as a tax-free interest-bearing account.

Some people overfund policies beyond IRS limits anyway. This creates what the IRS calls a modified endowment contract (MEC). Once a policy is considered a MEC, it is no longer a life insurance policy by IRS standards. That means any withdrawals from the policy’s cash value above the amount of premiums paid are considered taxable income.

The death benefit of a MEC is still tax-free to the policy’s beneficiaries.

Are life insurance premiums tax-deductible?

You typically do not collect any tax benefits for buying life insurance. If you itemize deductions when you file your tax return, do not count your life insurance premiums.

This can be verified by reviewing IRS Publication 502, which lists the types of insurance policies for which you cannot deduct premiums. Life insurance is included in that publication.


Jack Wolstenholm is the head of content at Breeze.

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