Life insurance is a contract between an insurer and a policyholder that pays out a sum of money to a beneficiary or beneficiaries upon the death of the insured person. People buy life insurance for various reasons, such as providing financial security for their loved ones, covering funeral costs, paying off debts, or leaving a legacy.
But what happens when you receive a life insurance payout? Do you have to pay taxes on it? The answer depends on several factors, such as how the payout is structured, who owns the policy, and how much money is involved.
In this article, we will explain when life insurance proceeds are taxable and when they are not, and how you can reduce or avoid taxes on them. We will cover the following topics:
- When are life insurance proceeds not taxable?
- When are life insurance proceeds taxable?
- How to reduce or avoid taxes on life insurance proceeds?
Key Takeaways
| Scenario | Taxable as Income | Taxable as Estate |
|---|---|---|
| Lump-sum payout to beneficiary | No | Yes, if estate value exceeds $12.06 million |
| Installment payout to beneficiary | Yes, on interest portion | Yes, if estate value exceeds $12.06 million |
| Policy owned by third party | Yes, if transferred for value | No |
| Policy owned by trust | No | No |
When Are Life Insurance Proceeds Not Taxable?
The general rule is that life insurance proceeds are not taxable as income if they are paid out entirely as a lump-sum, one-time payment to a beneficiary. This means that you do not have to report the payout on your income tax return or pay any income tax on it.
This rule applies in most cases, such as when:
- The policyholder is also the owner and the beneficiary of the policy. For example, if you buy a policy on your own life and name yourself as the beneficiary, you will not owe any income tax on the payout.
- The beneficiary is the spouse or a dependent of the policyholder. For example, if you buy a policy on your own life and name your spouse or your child as the beneficiary, they will not owe any income tax on the payout.
- The beneficiary is anyone else who has an insurable interest in the policyholder. For example, if you buy a policy on your own life and name your business partner or your creditor as the beneficiary, they will not owe any income tax on the payout.
The table below summarizes some common scenarios where life insurance proceeds are not taxable as income.
| Policyholder | Owner | Beneficiary | Taxable as Income |
|---|---|---|---|
| Self | Self | Self | No |
| Self | Self | Spouse | No |
| Self | Self | Child | No |
| Self | Self | Parent | No |
| Self | Self | Sibling | No |
| Self | Self | Friend | No |
| Self | Self | Business partner | No |
| Self | Self | Creditor | No |
When Are Life Insurance Proceeds Taxable?
There are some exceptions to the general rule that life insurance proceeds are taxable as income if they are paid out in installments, or if the policy is owned by a third party, or if the proceeds exceed the estate tax exemption.
Installment Payouts
If the beneficiary chooses to receive the life insurance payout in installments, such as annuities, rather than a lump sum, then the payout is partially taxable as income. The beneficiary will have to pay income tax on the interest portion of each installment, but not on the principal portion. The insurer will provide a Form 1099-R to report the taxable amount of each installment.
For example, if the beneficiary receives a $100,000 life insurance payout in 10 annual installments of $10,000 each, and each installment consists of $8,000 of principal and $2,000 of interest, then the beneficiary will have to pay income tax on $2,000 each year, but not on $8,000.
Policy Owned by Third Party
If the policy is owned by someone other than the policyholder, such as a corporation, a trust, or another individual, then the payout may be taxable as income to the beneficiary. This depends on whether the policy was transferred for value or not.
A policy is transferred for value if the owner receives any consideration in exchange for transferring the policy to someone else. Consideration can be anything of value, such as money, property, services, or a promise. If the policy is transferred for value, then the payout is taxable as income to the extent that it exceeds the sum of:
- The amount paid by the transferee for the policy
- The premiums paid by the transferee after the transfer
- The premiums paid by any prior transferees after their transfers
For example, if A buys a $100,000 policy on B’s life and pays $10,000 in premiums over 10 years, and then sells the policy to C for $20,000 and C pays $5,000 in premiums over 5 years, and then B dies and C receives the $100,000 payout, then C will have to pay income tax on $65,000 ($100,000 – $20,000 – $5,000 – $10,000).
There are some exceptions to the transfer for value rule, such as when:
- The transferee is the policyholder or the insured person
- The transferee is a partner of the policyholder or the insured person
- The transferee is a corporation in which the policyholder or the insured person is a shareholder or an officer
- The transfer is part of a tax-free exchange of policies
If none of these exceptions apply, then the payout is taxable as income to the beneficiary.
Estate Tax Exemption
Even if life insurance proceeds are not taxable as income to the beneficiary, they may still be taxable as part of the estate of the deceased person. This depends on whether the value of the estate exceeds the federal and state estate tax exemptions.
The federal estate tax exemption for 2023 is $12.06 million per person. This means that if the total value of your estate (including your life insurance proceeds) is less than $12.06 million when you die, your heirs will not have to pay any federal estate tax on it. However, if your estate value is more than $12.06 million when you die, your heirs will have to pay federal estate tax at a rate of up to 40% on the excess amount.
Some states also impose their own estate taxes with lower exemptions and rates than the federal estate tax. For example, New York has an estate tax exemption of $6.32 million per person for 2023 and a top rate of 16%. This means that if you die in New York with an estate worth more than $6.32 million (including your life insurance proceeds), your heirs will have to pay both federal and state estate taxes on it.
The table below summarizes some common scenarios where life insurance proceeds are taxable as part of the estate.
| Policyholder | Owner | Beneficiary | Estate Value (including life insurance proceeds) | Federal Estate Tax Exemption ($12.06 million) | State Estate Tax Exemption (varies by state) | Taxable as Estate |
|---|---|---|---|---|---|---|
| Self | Self | Spouse | $15 million | No (spousal exemption) | No (spousal exemption) | No |
| Self | Self | Child |