Life Insurance and Taxes

If you are the policyholder or the beneficiary in a life insurance policy, you’ve probably at one point have asked, Do I have to pay taxes on my life insurance?

Those words alone can easily make your head hurt, and putting them together seems downright unreasonable. But, there is a very straightforward answer to this most often asked question.

Is Life Insurance Taxable?

There are four different parts, or roles, in a life insurance policy:

  • The Insured – The person that is being covered by the policy.
  • The Owner – The person who owns the policy and can make any changes.
  • The Beneficiary – The person(s) to whom the death benefit will pay out.
  • The Payor – The person making the monthly premiums.

Each part can be a different person.

The best answer as to whether life insurance is taxable is that it’s extremely situational. Below is a situational life insurance tax chart.

Policy Owner Beneficiary Person Insured Death Benefit
Self Spouse Self Not Taxable
Self Children Self Part of Estate/Possible Taxation
Spouse Children Self Not Taxable
Spouse Spouse Self Not Taxable
Self Estate Self Taxable

It is essential to understand the structure of your life insurance policy to understand better how the policy will pay out. If you are unsure of your own tax situation, consult with a financial planner.

Taxes on Life Insurance as a Policy Holder

The policyholder or policy owner has the most power when it comes to a life insurance policy. This is the only person who can make beneficiary changes or cancel the policy.

If you are a policyholder or owner but are not the insured, then you should be free from any tax burden when the policy pays out.

However, if you are the insured and the policyholder, and you make anyone else the beneficiary other than your spouse, your death benefit is still tax-free but is considered part of your estate.

Taxes on Life Insurance as a Beneficiary

As a beneficiary, your only real responsibility is to be alive when the insured passes away to receive the death benefit. There won’t be any taxes owed when the life insurance pays out to you.

It is still a great idea to understand how the policy is structured as a beneficiary so that you know what actions need to be taken if you have to file the insurance claim.

Reaching Estate Tax Thresholds

In 2019 the IRS increased the estate tax thresholds to $11.4 million. This means that you can leave your heirs up to $11.4 million without having to worry about any federal taxes being paid.

According to DQYDJ, there are only about 1.3 Million people in the U.S with a net worth over $10 million, so most people don’t reach estate tax thresholds.

Tax Benefits of Life Insurance

The tax benefit of life insurance is the death benefit itself; the fact that you can get a lump sum of money and not have to pay any taxes on it is the purest form of the benefit of life insurance in general. You can use the payout for anything.

In cash value policies like whole life insurance, your premiums grow tax-free, and you can also withdraw and borrow from the cash value tax-free.

Some people even purchase life insurance to make sure their family is protected from any probate court proceedings upon their death.

The issue with this is that you don’t know how long this process could take; it can be anywhere from a few months to years. And if creditors file a claim against the estate, probate could take even longer.

A life insurance policy would bypass this entire process. The beneficiary or beneficiaries would file a claim with the life insurance company. Once the claim is approved, the death benefit is paid out to the named beneficiaries tax-free, typically in a lump sum payment.

Taxes on Death Benefit Proceeds

The death benefit of the policy will only pay out to the named beneficiaries which means that if you only have one beneficiary named, all of the funds will go to them tax-free.

However, any distribution of the funds from the beneficiary to other people over the amount of $15,000 will be considered taxable based on the Gifting Tax which can be up to 40%.

So if you intend to have more than one person receive a portion of the death benefit, be sure to designate them as primary beneficiaries.

Bottom Line

The layout of your life insurance policy will ultimately determine if taxes need to be paid on the death benefit or not. Be mindful of who owns the insurance policy and how this will affect the payout of your life insurance benefits.

Outside of replacing your income, not getting taxed on your life insurance death benefit is a great feature and another great reason to buy life insurance. You get to leave money to your family, and they get to enjoy 100% of it.

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