Buying life insurance is worth it for many people. It’s a great way to plan for the future and protect those you love most. When buying a policy that may be worth tens (or hundreds) of thousands of dollars, though, it’s important to consider the tax implications of those proceeds.
Here’s how your life insurance beneficiaries would be affected by your policy payout, and when those proceeds would be considered taxable.
When life insurance isn’t taxable
There are many different ways your life insurance policy can provide support, both before and after your death. Luckily, the proceeds aren’t usually taxable, which ensures these funds are available when your family needs them most.
1. Life insurance payouts to beneficiaries
The top reason for buying life insurance is to protect those you love if you were to die unexpectedly. This protection comes in the form of a death benefit paid out to your beneficiaries after your death, which can often be a significant sum of money.
Your beneficiaries don’t have to worry, though: your policy’s payout is generally not considered taxable. This means the funds do not need to be included in any gross income declarations after disbursement, and taxes will not be calculated on the death benefit paid.
2. Life insurance policy dividends
Some insurance policies build a cash value — such as participating whole life coverage plans — and will sometimes pay out dividends to policyholders if the company recognizes excess profits. These payments may come quarterly or annually (if they come at all) and are a nice surprise for policyholders who receive them.
Even better? These dividend payments themselves are not considered taxable income, as long as you don’t receive more in dividends than you paid in premiums for that policy.
3. Cashing out a permanent life insurance policy
Most permanent life insurance policies will build up a cash value based on the premiums paid as well as the interest and dividends earned. For some policyholders, though, this lifelong coverage (and the high price tag involved) may reach a point where it no longer feels necessary.
Whether you’re thinking about surrendering a whole life policy so you can then purchase term life coverage, or simply taking the cash and going home, the tax implications are the same. You can cash out a permanent policy at any time without paying taxes on the accrued value up to its basis.
The basis of an insurance policy is the value of premiums paid into the policy minus any withdrawals taken or dividends received. If your policy’s value at the time of cash-out exceeds the basis, that overage is subject to taxes.
4. Utilizing an accelerated death benefit
Some of the best life insurance policies offer an accelerated death benefit, which allows chronically or terminally ill policyholders to use life insurance funds before their death. If your policy includes this benefit and you qualify for an accelerated settlement, the funds can be withdrawn and used without tax liability.
It’s important to remember, however, that this benefit — and tax exemption — is available only if the insured’s illness qualifies.
When is life insurance taxable?
Although life insurance benefits are often non-taxable, there are a few situations in which you (or your beneficiaries) may wind up owing Uncle Sam.
1. Interest earned on installment or delayed payments
In some cases, you may want your policy’s death benefit to be disbursed in installments to your beneficiaries. Or, you may request that it be held for a period of time before the funds are released.
Generally speaking, the original death benefit will still be non-taxable in this case. However, any interest earned on the balance while it’s held will be subject to taxes.
2. When your dividends exceed premiums paid
A cash value policy’s dividends are not typically subject to taxes. However, if you get more back in dividends than you paid in premiums for your policy, expect to owe taxes on the excess amount.
3. If your estate is too valuable
The IRS allows you to provide for your loved ones in the form of gifts and life insurance proceeds. However, its generosity has a limit, and if you hit that limit, even death benefits can be subject to estate taxes.
If your life insurance beneficiary is anyone other than your spouse, the proceeds are considered part of your estate and will count toward your lifetime exclusion. The limit for this exclusion is $12.6 million for tax year 2022 ($12.92 million in 2023), which means that if the combination of your total estate and your net death benefit exceeds that amount, your heirs could be subject to estate taxes on the difference.
4. If your beneficiaries earn interest on proceeds
This may seem like common sense, but your beneficiaries may find themselves owing taxes if they put life insurance proceeds to work in an interest-bearing account.
Although your actual death benefit isn’t usually subject to taxes, the interest that money later earns is taxable. It’s still a smart idea for your loved ones to put the proceeds somewhere they can grow over time — it’s just important to realize that the future earnings will be considered taxable.
5. If you sell your policy to someone else
Some policyholders may want to sell their life insurance policy down the line, as a way of generating cash or bypassing high monthly premiums. This sale, called a life settlement, usually offers more than the cash surrender value of the policy but less than the net death benefit.
If you choose to sell your policy through a life settlement, you are responsible for taxes on any proceeds beyond the policy’s basis. The IRS calculates taxes differently depending on the type of policy and whether it was sold or surrendered. However, you can generally expect to pay taxes on the difference between what you receive and the policy’s cash value, accounting for premiums paid and withdrawals taken.
The bottom line
Life insurance is a great way to protect those you love as well as provide you with your own financial safety net. To maximize the impact of your policy, though, it’s important to understand when life insurance proceeds are (and are not) considered taxable.
Now that you know what to look for and how to minimize the tax burden of your benefits, it’s time to shop around for the perfect policy. Online insurance marketplaces make it easy to get coverage online in minutes.