Do I Have to Pay Taxes On a Life Insurance Payout?

All About Taxes and Life Insurance

Do I Have to Pay Taxes On a Life Insurance Payout?
June 21, 2016

Life insurance has grown in complexity over the years and, as a result, life insurance taxation issues have become equally complex. While you should consult with a tax professional to verify the tax status of any life insurance payout you receive, we can give you some general rules and guidelines to consider.

  • Pre-Tax or Post-Tax Money – Much of the tax status of the payout for a policy depends on whether premiums were paid with pre-tax or post-tax dollars. Always remember that, somewhere along the money trail, the taxman takes a cut. Almost anything you receive that is non-taxable means you or somebody else already paid the tax on those funds.

    The vast majority of policies, either employee or employer-purchased, are purchased with after-tax dollars. In that case, beneficiaries do not have to declare the death benefits as income and receive the benefits tax-free.

    If the policy was purchased with pre-tax funds – for example, as part of a tax-deferred retirement plan from your employer – the amount of the cash value component of the death benefit is considered to be taxable.

  • Proceeds Beyond the Death Benefit – Any interest payments that are included in the payout will be subject to tax, even if the majority of the benefit involved post-tax dollars.

    One example involves the choice of payment method for a life insurance payout (they are called settlement options and you as the beneficiary get to choose how you receive the proceeds; see your policy in the first few pages). Lump sum benefits are generally not subjected to taxes. However, with installment payments, the portion of your payout that has not yet been paid to you is generating interest income. You will have to pay taxes on that interest when you do receive it, since it has not been previously taxed.

    Similarly, if you surrender a policy for the cash value and receive more than the cost of the life insurance policy, the portion of the proceeds that you receive beyond the costs are taxable.

    The IRS draws a distinguishing line between life insurance policies and investment vehicles. A life insurance policy can have an investment component, but the primary purpose must be the life insurance element. These taxation rules are complex and may sometimes appear arbitrary, but they are designed to keep plans from manipulating loopholes and incorporating the collective tax benefits of investment programs into a life insurance policy.

  • State and Local Laws – Your state may have estate or inheritance taxes that apply to the payout. Not many states have these taxes anymore, and those who do have fairly high exemption limits (usually $1-$2 million). Federal estate taxes have an even higher exemption threshold (taxes apply over $5.25 million).

    These taxes affect the amount you eventually receive, but you will not have to pay the taxes yourself – they will be removed before you ever receive the money.

    An exception to this rule is when estate taxes are avoided by transferring ownership of a policy. The rules are complex, but it is possible for these cases to produce an unintentional gift status to the beneficiary (and therefore a tax obligation). Consult a professional if estate taxes are involved in any life insurance payout that you receive.

Again, we suggest consulting a professional for complex cases, but the short summary is that in most instances, death benefits are not considered taxable income to the beneficiary. If there are interest and proceeds that go beyond the death benefit, if pre-tax dollars are involved, or if estate and inheritance taxes apply, then portions of the life insurance payout may be taxable. When in doubt, check it out – with a qualified tax professional.


Photo ©iStock.com/vinnstock

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