If you have a life insurance policy when you die, your designated beneficiary will receive the money. In most cases, the beneficiary will not have to pay taxes on the money she receives from the policy; however, that isn't always the case, and in certain situations, your estate will owe taxes on a life insurance policy even if your beneficiary doesn't.
Life insurance death proceeds are generally not taxable income to the beneficiary, but there may still be life insurance tax implications depending on how the benefits are paid out and the type of policy you have.
How Does Life Insurance Work?
Life insurance can get complicated, but the basic principle is that during your life, you or your employer or any other person can buy a policy to insure your life. The owner of the policy must make payments over time, called premiums. In exchange for paying these premiums, the life insurance company agrees that when you die, it will pay a specified amount to a person you designate to receive it. That person is called the beneficiary; since the policy insures your life, you are the insured.
So, if your employer offers a garden-variety term life insurance policy of $50,000 as part of your employee benefits package, and you designate your brother as the beneficiary, your employer is the policy owner, while you are the insured and your brother is the beneficiary. If your employer pays the premiums as required, and you die before your brother, he will receive the $50,000 payout from the insurance company.
Are Lump Sum Life Insurance Death Benefits Taxable to the Beneficiary?
The IRS does not consider the life insurance payout amount as taxable income to the beneficiary. If your brother is your beneficiary and receives the $50,000 proceeds from your life insurance policy at your death in one lump sum, he doesn't have to report the money as taxable income to the IRS, and he won't have to pay taxes on it.
Life Insurance Paid in Installments: Interest Is Taxable to the Beneficiary
If your policy is set up to hold the $50,000 and pay it out in installments, however, there may be a different outcome. Some policies allow you to dictate how the beneficiary receives the money, and you can require that the funds are paid out over time instead of all at once. In that case, the life insurance company will hold the $50,000 in an interest-bearing account and make payments to the beneficiary as you requested. Although the original $50,000 is not taxable income, any interest earned in the account is taxable, and the beneficiary will have to report the interest as income and pay taxes on it.
Employer-Provided Life Insurance May Be Taxable Income to You
If your employer provides you with a term life insurance policy with a death benefit of $50,000 or less, the premiums the employer pays on your behalf are not considered taxable income to you. However, if your employer-sponsored life insurance has a death benefit that exceeds $50,000, you may have to pay taxes on a portion of the premiums paid on your behalf.
Tax on Life Insurance Dividends: Taxable to the Policy Owner
If your life insurance policy is a participating policy, and you own the policy, you may receive dividends from the insurer while you're still alive. Insurers use the premiums you pay to fund their operating costs; if your policy is a participating policy, and the insurer has a good year, you'll receive dividends representing the insurer's profits. The IRS considers these dividends to be a refund of your premiums, but if the dividends exceed the premiums you paid, you'll be taxed to that extent. For example, if you paid $5,000 in 2018 in insurance premiums and you receive a dividend from your participating policy in the amount $5,200, you'll have to pay taxes on $200 for the 2018 tax year. You will also be responsible to pay taxes on any interest you earn on the dividends once they're in a bank account, whether it's your account or your insurer's trust account.
Cash Value Life Insurance Policies
Term life insurance policies, which are the standard life insurance everyone usually thinks of when they hear "life insurance," have no cash value. The only value in a term life policy is to the beneficiary, who receives the death benefit. To the contrary, some life insurance policies, such as whole life policies and universal life policies, do have a cash surrender value. Unlike term life insurance, these policies accrue cash value and allow you to borrow from them or even cash them in (although doing so can reduce the death benefit).
Tax on Cash Value Life Insurance
If you take money out of a cash value life insurance policy, the money you take out is only taxable income in excess of your cost basis. Your basis is generally the amount you've already paid in premiums; that is, the cost you've already expended into the policy. If you've spent $10,000 on your policy premiums and cash out your policy for $10,000, you won't have to pay taxes on it, since you didn't make any money. These policies do keep your money in interest-bearing accounts, however, and all the interest you earn will be considered taxable income when you withdraw it.
Life Insurance and Estate Tax: Incidents of Ownership
If you are the owner of the policy insuring your life, it may be considered part of your taxable estate when you die. You're considered the owner if you meet the "incidents of ownership" standard. Incidents of ownership include the ability to name beneficiaries, change beneficiaries or borrow money from the policy. If you're the owner of the policy, the death benefit may be taxable to your estate even if it's not taxable to the beneficiary. You can avoid this by transferring the policy ownership to someone else as a gift, but if you do so within three years before you die, it will be charged to the estate as if you still owned it. However, estate tax only comes into play if you exceed the lifetime gift limit.
The Federal Estate Tax
If your life insurance proceeds end up being taxable to your estate, your estate may be hit with an estate tax if you're very wealthy. The federal estate tax is charged to the estate of a person whose estate value, when added to the gifts he gave away during his lifetime, exceeds a certain amount. Additionally, the lifetime gifts only count toward the total if they exceeded the exemption amount for the year in which they were made (the exemption changes periodically; for 2018, it's $15,000).
The Federal Estate Tax in Action
For someone who dies in 2018, the total lifetime gift threshold is very high: $11,180,000. This means your estate will only be subject to the estate tax if, over the course of your life (and including your estate when you die), you gave away more than $11,180,000 in excess of the yearly exemption amount. That figure will go up for 2019 to $11.4 million.
To illustrate this using simple math: if you die in 2018 having never given away any money to anyone, and you leave an estate worth $10 million, the estate will not be subject to the federal estate tax. This includes any of the taxable events related to life insurance policies. On the other hand, if you gave your niece $2 million in 2017 and died in 2018 leaving an estate of $10 million, your estate would be taxed on $805,000 because your $12 million in total gifts, minus the $15,000 exemption for the gift in 2017, is $11,985,000, which exceeds the 2018 threshold of $11,180,000 by $805,000.
- IRS: Publication 525 (2017), Taxable and Nontaxable Income
- AXA: Will my Beneficiaries have to Pay Taxes on the Proceeds of my Life Insurance Policy?
- Life Insurance & Disability Insurance Proceeds | Internal Revenue Service
- The Law Dictionary: Do You Have to Pay State or Federal Taxes on Money Received from a Life Insurance Policy?
- Ameriprise Financial: Tax Planning Tips: Life Insurance
- Nolo: Transfer Your Life Insurance and Decrease Your Estate Tax
- IRS: What's New - Estate and Gift Tax
- Forbes: IRS Announces Higher 2019 Estate And Gift Tax Limits
Rebecca K. McDowell is an attorney focusing on creditor and debtor law. She has a B.A. in English and a J.D. She has written finance and tax articles for Pocketsense and eHow.