Do You Have to Pay Taxes on Life Insurance?
Most of the time, you won't pay income taxes on money from a life insurance payout.
But you may need to pay estate taxes if the amount passed down is more than federal and/or state limits.
You could also owe income and capital gains taxes if you cash in your policy through a life insurance settlement or cancel the policy and take out the cash value.
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Are life insurance benefits taxable?
A life insurance death benefit, the money paid out after the policyholder dies, is not taxable if you choose a lump-sum, one-time payment.
If the life insurance is paid in several installments, though, the insurance company typically pays you interest on the amount they haven't given you yet. You'd have to pay income tax on the interest.
Life insurance and estate tax
How much estate tax you have to pay depends on your relationship with the deceased person. Spouses, for example, have different rules than children, parents and nonrelatives.
You can typically pass an unlimited amount of money and belongings on to a spouse without paying estate or inheritance taxes. So, if you're the beneficiary of your spouse's life insurance policy, the payout won't be taxed.
If you're the beneficiary of a policy for anyone besides your spouse, the life insurance payout is usually added to the value of their estate.
This won't be a problem if the estate's total value is less than the federal or state estate tax limits. Otherwise, you may have to pay estate or inheritance taxes on anything above that amount.
- Federal estate taxes affect estates larger than $13.99 million per person. Anything over that amount is taxed up to 40%. The exact percentage is based on the taxable amount of the estate.
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State estate and inheritance taxes vary. The minimum taxable estate size ranges from $1 million to $13.99 million. Tax rates can be as high as 35%, depending on where you live.
There are 15 states, plus the District of Columbia, with an inheritance or estate tax.
Life insurance proceeds are only considered part of an estate for tax purposes. They aren't included for other uses, such as paying creditors, unless the estate is the beneficiary or all of the beneficiaries have died.
How do I avoid tax on life insurance proceeds?
One way to avoid estate taxes on life insurance payouts is for the insured person to set up what's called an irrevocable life insurance trust (ILIT). They must create the trust while they are alive.
First, the insured person must work with an attorney to set up an irrevocable trust and name someone as the trustee, such as a relative or their attorney. Then they transfer ownership of the life insurance policy to the trust.
An irrevocable life insurance trust is an effective way to make sure the payout isn't taxable as part of the estate. But taxes may still be owed in a couple of situations:
- When setting up the trust, if the policy's cash value is more than the "gift tax exemption," the insured person may need to pay a "gift tax" when transferring ownership. The gift tax exemption for 2025 and 2026 is $19,000. ? This means you can give people up to $19,000 each without having to pay taxes on the gift.
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If the insured person dies within three years of transferring the life insurance to the trust, the policy will likely become part of the estate for tax purposes. This makes sure people can't help their heirs avoid taxes by giving away assets on their deathbed.
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Are life insurance living benefits taxed?
Many life insurance policies come with the option to use part of the potential payout if you become terminally or chronically ill. This means you can use your life insurance to help pay for the high treatment costs, which can be helpful, as severe illnesses often come with incredibly high hospital and treatment costs.
If you're diagnosed with a terminal or chronic illness, using part of the death benefit typically isn't taxable.
The IRS considers this the same as being the beneficiary of a life insurance payout.
Whole life insurance and taxes
Whole life insurance includes both a death benefit and a cash value component that grows over time. A portion of each payment goes toward the policy's cash value.
You can cancel a whole life insurance policy you own whenever you want. If you do this, you lose the death benefit but still get the current cash value of the policy.
Is the cash value of life insurance taxable?
If you cancel your own whole life policy, you'll have to pay taxes on part of the cash value.
That's because the part of your premium that goes toward your cash value earns interest from the life insurance company. You don't have to pay taxes on the interest until you take the money out of your policy, which means it's "tax-deferred." When you take the cash out, you must pay capital gains taxes on the interest.
If you don't want to cancel your policy, you can use its cash value as collateral for a tax-free loan from the insurance company. However, if the loan amount is greater than the cash value, the policy might lapse, and you would then have to pay taxes on the loan.
Are life insurance policy dividends taxable?
Dividend payments on your own life insurance policy aren't taxable unless the amount is more than you paid for your policy that year.
If you have whole life insurance from a mutual insurance company, you may get dividends from the company because they're owned by policyholders. So, the company often distributes excess income through annual dividends.
Taxes on life insurance settlements
If you no longer need your own policy — perhaps because your kids have grown up and don't rely on you financially anymore — you may be able to get a life insurance settlement.
With a life insurance settlement, you'd get a cash payout by selling your policy to a third party, usually a company.
The company would become both the policyholder and beneficiary. And they'd take over paying monthly payments.
As the seller, you must pay taxes on the money you get from the sale. But term and whole life insurance are taxed differently when this happens.
Taxes on a term life insurance settlement
Taxes on a term life insurance settlement are fairly straightforward. The policy owner must pay capital gains tax on the money from the settlement, minus what's been paid in premiums.
For example, say you've owned a term life insurance policy for 10 years and pay $30 per month. If you sell your policy for $20,000, you'd have to pay capital gains taxes on $16,400.
Taxes on a whole life insurance settlement
You must pay income and capital gains taxes on a whole life insurance settlement.
First, you'd pay income tax on your policy's cash value minus the amount you've paid in premiums. Next, you'd pay capital gains tax on the settlement amount but again subtract what you've paid in premiums.
This is important because capital gains have lower tax rates than income if you've had your policy for more than 366 days.
Example: You sell your life insurance policy, which has a cash value of $150,000, for a $200,000 settlement. You've paid $125,000 in premiums.
You will pay income tax on $25,000. That's the difference between the cash value and what you've paid in premiums.
To calculate the capital gains tax, subtract the payments you've made from the settlement amount, which leaves $75,000. Then, deduct the amount you pay income tax on, which is $25,000. You'd have to pay the capital gains tax on the remaining $50,000.
| Step 1: Calculating the total gain | |
| Amount received | $200,000 |
| Premiums paid | -$125,000 |
| Total gain | $75,000 |
| Step 2: Calculating income tax | |
| Cash value | $150,000 |
| Premiums paid | -$125,000 |
| Amount subject to income tax | $25,000 |
| Step 3: Calculating capital gains tax | |
| Total gain | $75,000 |
| Amount subject to income tax | -$25,000 |
| Amount subject to capital gains tax | $50,000 |
Tax consequences of canceling your life insurance policy
If you cancel your life insurance policy, the taxable amount is tied to the cash value.
You won't owe taxes if the life insurance policy's "cash surrender value" is less than what you've paid in premiums. But if the value is more than what you've paid, the difference is taxable as income.
Since term life insurance policies don't have a cash value, you won't owe taxes if you cancel. But you won't get any money from the insurance company either.
Are life insurance premiums tax deductible?
Life insurance premiums aren't typically tax deductible. In fact, you may have to pay taxes if you have group life insurance through your employer over a certain amount of coverage.
Some employers include a life insurance policy as a free perk for their employees, the same way they might offer health insurance or commuter benefits.
If the value of the policy is less than $50,000, you don't have to pay any additional taxes.
But if the value of the policy is over $50,000, your employer has to report the cost of the policy to the IRS as income, and you'll pay taxes on that amount when you file your taxes each year.
With group coverage, the insurance company balanced its risk across many people with different health backgrounds. So, if you're unhealthy or older, you may get a much lower rate than you would with an individual policy.
Frequently asked questions
Is life insurance taxable?
Life insurance payouts aren't usually taxable as income. However, you may have to pay capital gains or income taxes if you cancel your own policy and withdraw the cash value or sell your policy in a life insurance settlement.
Do beneficiaries pay taxes on life insurance benefits?
Beneficiaries may have to pay federal estate taxes if the estate's total value is more than $13.99 million. If you live in a state that charges an estate tax, and the value of your estate exceeds your state's threshold ($1 million-$13.99 million, depending on the state), your beneficiaries may need to pay state tax as well. Even if your state does not charge estate taxes, your beneficiaries may have to pay inheritance taxes, depending on where they live.
How much is life insurance taxed?
Most people don't have to pay taxes on a life insurance payout. But estates that are very large may require federal or state estate taxes or an inheritance tax. The federal estate tax rate is up to 40%. State estate and inheritance taxes can be as high as 35%.
Methodology
Estate tax information was sourced from the IRS.
About the Author
Lead Writer
Matt Timmons is a Lead Writer on the insurance team at ValuePenguin, where he writes in-depth and timely pieces helping find the right coverage for them.
He's covered insurance at ValuePenguin since 2018, specializing in auto and home insurance, as well as life insurance. He's paid special attention to the EV insurance market, where prices are much higher than for gas cars.
Before he started writing about personal finance, Matt wrote about professional skills and online tools at an e-learning company.
How insurance helped Matt
During freshman orientation in college, Matt's iPod was stolen off his table while he was eating lunch. Luckily, he'd bought a college insurance plan the day before and he had money to buy a replacement before classes started.
Expertise
- Auto insurance
- Home insurance
- Insurance rate analysis
- Life insurance
Referenced by
- CNBC
- Miami Herald
- Yahoo! Finance
Education
- BA, Wesleyan University
Editorial Note: The content of this article is based on the author's opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.
