Is life insurance taxable?

Knowing when life insurance is taxable and how to avoid taxation can help families ensure their loved ones get all of their policy’s proceeds. (iStock)

Life insurance is designed to pay out a death benefit to your beneficiaries if you pass away while the policy is in effect, usually in the form of a lump sum.

When large amounts of money change hands, taxes are typically involved. Fortunately, that isn’t usually the case with life insurance.

While there are a few unique instances that could warrant taxation — like inheriting a large estate or electing to receive policy benefits in installments – there are strategies you can use to avoid paying taxes on life insurance.

If you want to begin estate planning, then learn the basics of life insurance by visiting Credible for free life insurance quotes and how certain plans would affect your beneficiaries. 

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Do you have to pay taxes on money received from a life insurance policy?

Generally, beneficiaries don’t have to pay taxes on money received from a life insurance policy because the IRS doesn’t consider life insurance proceeds as taxable income.

If you have an accelerated death benefit rider and need to access your own policy’s proceeds due to a terminal illness, the money will not be taxed, either.

Visit Credible to get free life insurance quotes and find the right policy for you and your family.

While you probably won’t have to worry about taxes on a life insurance payout, the situations below are exceptions to the standard:

  • Estate taxes: If all the policyholder’s assets meet the IRS’ federal estate tax threshold, which is set at $11.7 million in 2021, the policy’s proceeds could be taxable.
  • Installment interest: If you choose to receive policy benefits in incremental installments instead of a one-time life insurance payout, you’ll be on the hook for taxes on any interest that accrues.
  • Gift tax: If an individual takes out a life insurance policy on someone other than him/herself, the policy’s benefits are considered a gift. Any monetary gifts above $15,000 are taxable.
  • Cash value: If the policyholder dies with an outstanding cash value loan, the policy’s death benefit could be used to settle it. Likewise, any amount the policyholder borrows beyond what they’ve paid into the policy is taxable.

While the scenarios above mostly pertain to beneficiaries, there are a few more situations that could leave the policyholder responsible for taxes.

In addition to taking out a policy loan, when you sell or surrender your policy and the cash value exceeds the amount you’ve contributed in premiums, the excess amount is taxable.

If you’re considering a new policy, explore pricing and find the right life insurance company and plan that fits your needs on Credible.

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How do you avoid taxation on life insurance proceeds?

Taxes on life insurance proceeds are rare, but they aren’t unheard of. Beneficiaries of large estates face the highest risk of owing taxes on life insurance benefits.

Luckily, there are strategies for working around this situation, as well as some others mentioned above:

  • Transfer ownership: To avoid taxation, you can work with your life insurance company to legally transfer the policy to a new owner, like the beneficiary. That way, the policy’s proceeds are not included in the estate. Just note that a transfer puts the responsibility of making premiums and the ability to change the policy in the new owner’s hands.
  • Use an irrevocable trust: An alternative that guarantees the policyholder’s wishes for the policy are honored and allows them to maintain premiums is an irrevocable life insurance trust. An ILIT irreversibly transfers ownership of the policy to the trust, removing it from the taxable estate.
  • Choose a lump sum payout: Installment payouts accrue interest and are susceptible to taxation; lump sump payments aren’t. While receiving a large sum at once can feel overwhelming, consider the cost of taxes on incremental payments if you’re the beneficiary of a policy.
  • Borrow carefully: Policy loans aren’t always wise. If you fail to pay one back, the policy could lapse, become taxable, or lower the death benefit. Depending on your credit score and other factors, a personal loan may make more sense.  Before making a decision, compare personal loan rates with Credible.

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Key takeaways

Is life insurance taxable? Outside a few unique situations, life insurance proceeds aren’t taxable. 

But if you’re worried about you or your beneficiaries’ life insurance benefits becoming taxable, remember there are steps you can take to ensure your family gets the most out of the policy.

  • Be mindful of the tax laws surrounding life insurance, gift, and inheritance taxes as you set up your policy.
  • Approach policy loans carefully, weighing the pros and cons and considering alternatives.
  • Consider working with a financial advisor to establish a plan, especially if you’re a high-income family likely to deal with estate taxes.

Make sure you and your loved ones have the right coverage in place. You can explore pricing and find the right life insurance product that fits your needs on Credible.

Have a finance-related question, but don't know who to ask? Email The Credible Money Expert at [email protected] and your question might be answered by Credible in our Money Expert column.

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