Do You Pay Taxes on Life Insurance Policies?
Key takeaways:
Beneficiaries usually do not have to pay taxes on the proceeds from life insurance.
If you cash out of a policy, you may have to pay taxes.
You should file a life insurance claim as soon as you can to get paid faster.
Approximately 23% of Americans — nearly 1 in 4 — do not have life insurance. The main reason is that people believe they cannot afford it.
Life insurance can be a cost-effective way to provide for the long-term support of your family. For example: A 2022 survey from Quotacy shows that monthly premiums range from $18.74 to $114.48 for healthy males between the ages of 25 to 55 who don’t smoke. This is for a 20-year, $500,000 term life insurance policy.
Life insurance also has tax benefits for the policyholder and beneficiaries. Below, we’ll review how taxes work on life insurance policies and how to file a claim.
Prescription Savings Are Just the Beginning
See what other benefits you qualify for—from cashback cards to cheaper insurance.
Do the beneficiaries have to pay tax on life insurance?
Generally, the proceeds of life insurance (whole life, term, or other policies) are tax-free for the beneficiary. That means you won’t have to report a life insurance payout as income on your tax return.
There are some exceptions. For example: Let’s say you earn interest on a life insurance policy. You will then have to report the interest received on your tax return.
This is also the case if you receive your payout as an installment instead of a lump sum. You will have to report any interest earned on the remaining balance held by the insurance company. This interest is subject to income tax. The insurance company should send you Form 1099-INT so you can report the interest on your tax return.
A life insurance payout can also trigger gift taxes. Suppose you buy a policy on the life of your spouse, and your son is the beneficiary. When there is a payout on death, the IRS will consider that the son received a gift, and there may be a gift tax.
Another exception is when you buy an existing policy. For example, you buy a policy for $10,000 that has a death benefit of $100,000. You then pay $30,000 in premiums. When the policy pays out, you will be subject to taxes on the $60,000, which is the $100,000 distributed minus the $40,000 for the purchase price and premiums.
Does the policyholder pay taxes on their life insurance?
If you own a term policy, then there are no taxes owed during the life of the policy. This type of insurance has an end date, such as 20 years, 30 years, and so on. It only pays a death benefit if the insured person dies during the time period.
Read more like this
Explore these related articles, suggested for readers like you.
A permanent life insurance policy, such as whole life insurance, has a cash-value component. If you surrender your policy and take the cash value out, you may owe taxes. This is the case if the premiums you contributed — minus all dividends received — exceed the cash value.
A policy may pay annual dividends. The dividends you earn are generally tax-free. But if they exceed the premiums paid, they will be subject to taxes.
Generally, you won’t have to pay taxes when you take out a loan against your policy. But if the value of your loan exceeds the total premiums you paid, you may be on the hook for taxes.
For example, suppose you have a whole life insurance policy. Your total premiums paid equals $50,000, and you took a loan from the policy for $60,000. If the policy lapses, you will pay taxes on the difference, which is $10,000.
Life insurance may become part of the estate of the policyholder. If the total value of the assets exceed $11.70 million in 2021 or $12.06 million in 2022, the estate owes a tax. You can avoid owing taxes by naming one or more beneficiaries for the policy or having the policy as part of a trust. You should seek the help of a qualified estate attorney.
Do you pay taxes on accelerated death benefits?
Your policy may have an accelerated death benefit (ADB). This allows you to access the death benefit while you’re alive if you have a chronic illness, terminal disease, or other qualifying event. There is a cap — usually around 50% — on the amount of the death benefit you can use early. You can use the funds for any purpose, including medical expenses. If a doctor certifies that you are terminally ill and likely to die within 24 months, the amount you withdraw from your insurance policy is tax-free.
This money is also tax-free if you have a chronic illness and your ADB withdrawals are under $400 per day. But the cap on how much you can withdraw still applies.
When should the beneficiary file a claim for life insurance benefits?
There is no time limit for filing a life insurance claim. But you should do so as early as you can. This ensures you will get your proceeds faster. The process can take anywhere from 2 weeks to 2 months.
What is the process of filing a life insurance claim?
Call the insurance agent of the deceased or go directly to the carrier. Request a claim form. Besides a death certificate, you will need the following information:
Policy number
Social Security number of the deceased
Date of birth and death
Place of death
Once you submit the claim, you can follow the progress from the insurance company’s online portal. When approved, you decide how you want to receive the benefit, such as a lump sum, annuity, or installment. You can receive a check or direct deposit.
Can the IRS go after life insurance proceeds?
The IRS has strong collection powers, and it can place a lien on insurance proceeds. However, you may be able to avoid this by using an insurance trust. This is an irrevocable trust because you no longer have ownership of the policy. The trust owns it.
You must set this up before you have tax problems. This is a complex area of the tax law, and you should seek the advice of a tax professional or lawyer.
How does inheriting someone’s life insurance policy change my taxes?
If you include the insurance policy in a will, this may not matter. The reason is that the proceeds are distributed to the beneficiaries directly. If there are no beneficiaries, then the proceeds go to the deceased’s estate. If so, it will add to the value of the assets and could be subject to the federal estate tax.
When should you cash out a whole life insurance policy?
Whole life insurance lasts for the entire life of the insured and has cash value. The cash accumulated in the account grows according to a set flat interest rate. This is so long as the policyholder continues to pay the premiums.
“You can take out the cash value any time you want, such as with a loan,” said John Boutte, a licensed insurance agent in San Antonio, Texas. “You can use the money for healthcare expenses or what expenditures you please.”
If you withdraw all the cash from your account — or surrender a policy — you might have to pay fees and taxes. The fees are a percentage of the cash value. Insurance companies charge surrender fees primarily to recoup the commissions paid to insurance agents.
Because of the fees, it is best to seek the advice from your insurance agent or financial planner before you cash out of the policy.
Does the IRS know when you inherit money?
There is no requirement to report inheritances to the IRS. But you need to disclose on your tax return any earnings generated from your insurance policy. For example, suppose you received a $500,000 payout and deposited it in a savings account. The interest you earn is taxable, and the bank will send you a 1099-INT during tax season that discloses the amount.
Does inheritance affect Social Security?
The Social Security Administration and Social Security Disability Insurance (SSDI) calculates most benefits according to the earnings from a job or self-employment. Therefore, an inheritance, payouts from life insurance, or the cash out of a permanent life insurance policy won’t affect your benefits.
But you may not be eligible for Supplemental Security Income (SSI) if you receive an inheritance. The reason is that an individual cannot have assets over $2,000, or $3,000 for a couple.
The bottom line
For any type of insurance policy, the beneficiary usually pays no income taxes on the receipt of the death benefit. However, there are situations that can trigger taxes, such as earning interest, selling a policy, or canceling a permanent policy.
The rules can be complex. This is why you should seek advice from an insurance agent or financial planner when you plan to make a change with your policy.
Why trust our experts?
References
Consumer Affairs. (2022). What would happen to your family if you died?
Cornelius, N. (2022). Average life insurance rates for 2022. Quotacy.
Internal Revenue Service. (2019). Form 706.
Internal Revenue Service. (2021). About Form 1099-INT, interest income.
Internal Revenue Service. (2021). Estate tax.
Internal Revenue Service. (2022). About Form 709, United States gift (and generation-skipping transfer) tax return.
Internal Revenue Service. (2022). Abusive trust tax evasion schemes - special types of trusts.
Internal Revenue Service. (2022). Form 1099-INT.
Internal Revenue Service. (2022). Gift tax.
Internal Revenue Service. (2022). Life insurance & disability insurance proceeds.
LaGrotte, L. (n.d.). What happens when you surrender a life insurance policy? Life Settlement Advisors.
Legal Information Institute. (n.d.). 26 U.S. code § 6321 - lien for taxes.
Social Security Administration. (n.d.). Social Security Administration.
This article is solely for informational purposes. This article is not professional advice concerning insurance, financial, accounting, tax, or legal matters. All content herein is provided “as is” without any representations or warranties, express or implied. Always consult an appropriate professional when you have specific questions about any insurance, financial, or legal matter.
