Is life insurance taxable? Five things you need to know
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
What to know about life insurance and tax
Typically, death benefits paid out from a life insurance policy are not considered gross income and don't have to be reported as such for tax purposes.
Term life insurance is the most straight forward option with regards to understanding the tax implications – basically, you pay for your policy coverage which provides your beneficiary an income tax-free lump sum upon your death. Beneficiaries or owners may pay taxes on permanent life insurance policies in certain contexts, so it is important to understand when and how life insurance is taxed.
We’re here to share some answers that may help you better understand the tax implications of life insurance.
1. Cash value tax implications
Before reviewing common situations when life insurance is taxed, you first need to learn how cash value works.
Some permanent life insurance solutions like whole life or guaranteed universal life insurance allow you to accumulate money in a cash value account, similar to a savings account.
Your premium, after subtracting fees, is deposited into an interest bearing account. After charging monthly deductions for the cost of insurance and maintenance costs, the remaining amount is called the “cash value.” These funds may gain earnings from stock or bond investments, indexed accounts, or by a fixed rate of interest depending on your policy type and provider rules.
As the policyholder, you can benefit from the cash value during your lifetime. Depending on your policy’s specific terms, you might be able to withdraw from your cash value or borrow against it for expenses, such as medical bills or a down payment on a house. However, any such withdrawal can have negative impacts upon your policy performance or cause it to lapse prematurely.
The part of your cash value made up of interest or investment gains is where you want to watch for taxes. You can make non-taxable withdrawals from your cash value as long as the amount is less than or equal to the cash amount you’ve put in. Note, if you take from the interest or investment gains you will be subject to income taxes on that portion.
It's important to remember that not returning a cash value loan in full may have tax penalties and diminish your death benefit. In some instances, this may also cause your policy to lapse.
Aside from cash value, if you have a policy through a mutual insurance company you may receive annual dividends, which can be one of the main tax benefits of life insurance. Because the IRS sees these dividends as a return of your premiums, rather than income, life insurance dividends are not taxable. (Of course, there’s a “but”). But, if the dividends you get paid in any year exceed the premiums you paid, they you may need to pay taxes on the difference.
2. Taxes when surrendering a permanent life policy
Surrendering a permanent life policy (such as a universal life policy or a whole life policy) for a portion of its cash value (also known as cash surrender value) is another instance that might require you to pay taxes.
Surrendering a policy will give you access to cash, but it comes with a price. Whatever money you receive past the total amount of premiums you paid, or the “cash basis,” will be taxed as ordinary income. Of course, your final costs will depend on your tax bracket.
Here’s how it works:
Imagine you are in the 25% tax bracket and you’ve already contributed $10,000 to your cash value. Say with your policy, your cash value increased to $13,000.
Hypothetically speaking, if you surrender your policy, after paying roughly $1,000 in charges, you’ll receive $12,000 cash. Since this number exceeds your cash value input by $2,000, you’ll have to pay a 25% tax on the $2,000.
3. Taxable incremental payouts (Annuities)
Aside from a lump sum of money, some life insurance policies allow for the life insurance death benefit to be distributed to your beneficiaries in incremental payouts, or as an annuity. Perhaps your beneficiaries are not financially-savvy, have a hard time managing money, or you just don’t want to burden them with having to deal with a large one-time payout. Monthly installments delivered with the same frequency as your lost earnings might be easier for beneficiaries to manage, especially during the grieving period.
In this case, your beneficiaries won’t be taxed on the death benefit, but may be taxed on any interest acquired over the years. Make sure to discuss the options with a financial specialist and with your loved ones before choosing between taking
the death benefit as a lump sum or as incremental payouts.
4. Estate taxes
When your beneficiary is a spouse, there are generally no federal income taxes or estate taxes, regardless of how large the estate may be. That’s because the IRS created an unlimited marital deduction, exempting death benefits paid to a spouse. If your beneficiary is not your spouse, then there are some things you should know.
When the death benefit leads to your assets surpassing the estate tax point, you might have your estate taxed. The good news is that federal estate taxes apply only to high-value estates.
In 2021, the rules were changed to set the federal estate tax threshold at $11.7 million, so unless your death benefit increases your estate value over this limit, you shouldn’t have to worry about federal estate taxes. Although, you should consult your financial advisor about any possible state taxes.
Taxes that might apply to estate owners:
- Generation-skipping transfer tax — this impacts assets that were skipped by a generation (for example, a grandparent leaving property to a grandchild instead of their own child). This type of tax includes the same exemption limits as the estate tax.
- Inheritance tax — this is collected by a handful of states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) on inherited money, property, investments, or other valuable assets. The inheritance tax varies from 15 to 20%.
- Gift tax — this federal tax is placed on any assets given as gifts (e.g. those above the annual exclusion of $15,000 per donor per donee). The goal is to discourage people from making lifetime gifts as a way to reduce their estate. The gift tax shares the same exemption of $11.7 million, so giving taxable gifts can reduce the exemption available for the estate tax.
5. Group life insurance impact on taxes
Many people have group life insurance through their employers. Coverage like this is usually limited and often doesn’t protect against lost earnings to the extent that an individual policy can. Depending on the type of coverage and the amount offered by your group life insurance policy, you might have to pay taxes.
If the company you work for is paying for all, or part, of the cost of group-term insurance and the total amount of your coverage is under $50,000, there are no tax consequences. If the cost of coverage exceeds $50,000, and is considered carried by the employer, then the cost of coverage is treated as income and is subject to social security and Medicare taxes.
* Note that your employer is required to include the cost of group-term life insurance beyond the $50,000 coverage in your wages and report this on your Form W-2.
Some employers may even pay for life insurance coverage that extends to your spouse or dependents–part of which may be also subject to taxes. It is recommended to clarify the type of insurance and coverage amount with your employer to better understand your tax implications.
6. Bonus: Return of premium life insurance policies — Taxable or not?
Return of premium (ROP) is a type of term life insurance that is about 30% more expensive than a term life policy, but it comes with a feature that some people bet on:
If you outlive your term, all the premiums paid throughout the life of the policy are refunded to you, tax-free.
A ROP policy allows you to enjoy a chunk of money well before reaching retirement, so many people see it as a forced savings account, especially if they have a hard time putting money aside. Keep in mind, by choosing this route you’ll be missing out on decades of potential growth from compound interest. In the end, your ROP payments might produce more money if invested elsewhere.
The bottom line:
Life insurance policies have tax implications, and understanding them will help you and your beneficiaries avoid surprises. The tax code is complicated, which is why it is recommended to always consult with a tax advisor for specifics on how you can benefit from personal tax planning.
Overall, life insurance provides you with security and some tax benefits:
- Your family receives a death benefit, free of income taxes. This is because the IRS looks at the death benefit as a reimbursement for a loss, not a source of income.
- Some types of permanent life insurance allow you to place your money in stable investments and build a tax-deferred retirement plan through cash value, dividends, or a lifetime annuity.
- Even with large estates, you generally won’t pay taxes if your spouse is your beneficiary.
- You can earn tax-deferred growth. Increases to cash value can grow year after year tax-free.
- You don’t pay taxes on dividends unless they exceed the premiums you paid in a given year.
- You have options for cash withdrawals and loans without paying taxes (as long as you pay any loans back). - Surrender payouts with minimal losses. You only pay taxes on the gain in cash value.
- Transferring ownership with gift taxes, which, if done properly, are much lower than estate taxes.
Whether life insurance is taxed or not shouldn't stop you from getting the coverage you need. At Legal & General America, we’re here to help answer your life insurance questions with full transparency, so you can choose the right policy for your family’s financial needs.
Consider a term life policy from a trustworthy insurance company
Legal & General America is a top-five provider of term life insurance in the US providing coverage for over 1.5 million Americans. Our financial strength and excellent customer service make us one of the most reliable insurance carriers in the country.
We take pride in the fact that no other life insurance company offers more term options than we do, with coverage for as low as $7 dollars per month!
From the application process through detailed policy options, we’ll guide you step-by-step, so you can purchase peace of mind for your family.