The most recognized benefit of life insurance is the death benefit. When a policyholder dies, the beneficiary receives a cash payout.
Generally, you do not have to pay taxes on proceeds from a life insurance payout. However, there are a few exceptions to this rule.
Is life insurance taxable
According to the IRS, “life insurance proceeds you receive as a beneficiary due to the death of the insured person aren’t included in gross income and you don’t have to report them. However, any interest you receive is taxable and you should report it as interest received.”
Term life insurance doesn’t have cash value, and the death benefit comes as a lump-sum payment. However, if you have permanent life insurance policies, there may be tax implications due to the cash value component.
Term life insurance | Permanent life insurance |
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Exceptions to the non-taxable rule on life insurance payouts
Mark Williams, CEO of Brokers International, told Insider that there are some instances where life insurance beneficiaries may have to pay taxes on the death benefit:
1. Cash value permanent life insurance policies
2. When life insurance is written off as a business expense
Cash value permanent life insurance policies
Cash value is a feature unique to permanent life insurance policies. All permanent life insurance policies have death benefits as well as a cash value that grows on a tax-deferred basis. The big difference between the types of permanent life insurance policies is how they manage the cash value — in the insurance company’s portfolio, stock market, or annuities.
Williams warned that because the money inside the permanent life insurance policy (cash value) has been growing on a tax-deferred basis, you will pay taxes on the cash value upon surrendering the policy or if it’s paid out to a beneficiary. The amount of the death benefit itself is not taxable, but the cash value and its interest will be.
If you are the beneficiary of a permanent life insurance policy, the insurer will give you options on how you can receive your death benefit: as a lump-sum payment or incrementally. Incremental payments will trigger a taxable event.
High net-worth wealth individuals typically have permanent life policies to handle estate and inheritance tax concerns. Williams said that because cash value grows tax-deferred, some people overfund their permanent life insurance. This will trigger a taxable event.
It’s important to talk to your accountant if you are the beneficiary of a permanent life insurance policy to understand the tax implications.
Types of permanent life insurance | Best for | Where is the cash value invested |
Whole Life | Guaranteeing exact same premium for the life of the policy | In your insurance company’s portfolio |
Universal Life | The flexibility to change your premium, death benefit, and cash value over time | In your insurance company’s portfolio |
Guaranteed Universal Life | Flexibility of a universal life policy with guaranteed rates of whole life | In your insurance company’s portfolio |
Indexed Universal Life | Like universal life instead of interest rates in fixed indexed market | Fixed index stocks and options |
Variable Life | Investing your cash value in the stock market rather than your insurance company | Stock market |
Variable Universal Life | The flexibility to change your death benefit, investing in the stock market rather than your insurance company | Stock market |
Writing off premiums as a business expense
Williams said writing off life insurance premiums on your taxes as a business expense can trigger a taxable event for the beneficiary. This can happen if you have an employer group life insurance policy or as a business partner. He gave the following example:
Two business partners have 50/50 ownership in a business venture with the right to purchase the other’s ownership interest in the event of death. They purchased a business life insurance policy and write off the premiums as a business expense. Upon the death of one partner, the surviving partner uses the life insurance proceeds to purchase the deceased partner’s ownership interest. This will trigger a taxable event.
If your employer provides you with group life insurance and writes off premiums paid as a business expense, if you die while employed, your beneficiary may have to pay taxes on the death benefit, particularly if you increased your benefit amount.
If you are the beneficiary of a group life insurance policy or a business partner, it’s important to talk to your accountant to understand the tax implications.
Your life insurance needs change as you age, and you’ll need to consider children, marriage, divorce, retirement, and caring for aging parents. Consider consulting a financial advisor, estates attorney, and accountant to ensure you have the proper coverage for your goals and life changes. The best life insurance policy for you depends on your budget and financial situation.