The taxability of life insurance: An essential guide

Life insurance is one of the best ways you can continue to help those who mean the most to you after you pass away. Whether to pay for unexpected funeral costs, provide financial support for your loved ones, donate to your favorite causes or transfer wealth to the next generation, death benefits are much-needed funds that can make navigating a difficult process easier for your family.

To make the most of these payouts, life insurance contracts have unique features that can help families manage their tax liability. That's why it's important to know about the taxability of life insurance. Here are the key details to understand.

In most cases, a life insurance death benefit is not included in your beneficiary's taxable income, making it an efficient method for providing for your loved ones and treasured charities after you pass. That said, there are exceptions.

Most families use life insurance to protect against the untimely death of a wage earner or caregiver, and those types of payouts are typically tax-advantaged for beneficiaries. The same is true when an individual obtains a life insurance contract and names family members as beneficiaries as part of a wealth transfer strategy.

That's important because the death benefit can help loved ones avoid financial hardship and pursue financial goals. While life will change for beneficiaries, it's helpful for them to keep as much money as possible to help meet their needs. The complexity of dealing with taxes can add an additional burden during a difficult time.

All that said, some payouts may have tax consequences.

There are several circumstances in which life insurance payouts to beneficiaries can be taxed. These situations don't arise often, but you might encounter them, so it's critical to know when you risk triggering taxes. These are some of the most common exceptions, but others exist. It's wise to check with a tax professional before you buy life insurance or change an existing contract.

A death benefit can be a substantial amount of money. Interest may be earned on death proceeds from the date of death until the insurance company disburses the funds. Additionally, when a beneficiary qualifies to receive those funds, they have several options for the payout. For example, they can take the money and invest it or pay off debt. They might also leave it with the insurance company in an interest-bearing account while they decide what to do with it. Whether they put the money in the bank, invest for growth or leave it with the insurer, any interest earnings on the death benefit generally are taxable (unless the beneficiary places the money in a tax-deferred vehicle, which might allow them to postpone taxation).

It might also be possible to receive a stream of income payments from the insurer. In that case, a portion of each payment would be a tax-free portion of the death benefit, and the remainder would be taxable interest earnings.

It's possible to indirectly trigger taxes when you have life insurance. Again, beneficiaries often receive death benefits without incurring significant income tax. However, depending on the ownership of the life insurance and other planning details such as trusts, a death benefit may dramatically increase the size of your taxable estate. Federal and state estate/inheritance taxes may apply if the size of your taxable estate exceeds certain thresholds. Your heirs could potentially end up with less money due to estate/inheritance taxes.

Minimizing the size of your taxable estate (generally those assets you own at death), through planning with an attorney can reduce the impact of estate/inheritance taxes and maximize the assets that go to your heirs. However, you might have good reasons for directly owning the life insurance and taxes are only one piece of the puzzle.

Be mindful of multiple levels of estate and inheritance taxes when passing assets to others. For instance, upon your passing, your spouse would generally receive assets without triggering estate taxes. But when your spouse eventually dies, subsequent beneficiaries might face estate and inheritance taxes. An estate tax attorney can help you anticipate various scenarios and design strategies to manage taxes for heirs.

After your contract has been issued, certain changes could trigger tax consequences. For example, you might create a tax liability if you sell or assign the contract to somebody else for value. That doesn't mean you should never change your life insurance, but you'll want to understand any tax consequences before moving forward with doing so.

When a life insurance contract has a cash value, it does not change the usually tax-advantaged nature of the death benefit. The buildup inside of a permanent life insurance contract does not generally create taxable income. For example, when your cash value earns interest or otherwise grows, those earnings inside of the contract are not taxed.

However, permanent life insurance contracts introduce additional complications.

If you want to use the cash value during your lifetime, you might be able to take loans or withdrawals from your life insurance.¹ Any money you take out is generally not included in your taxable income—unless your contract is a Modified Endowment Contract (MEC)² (where your cash value life insurance contract surpasses federal tax limits) or you exceed your investment in the contract, known as basis.

Basis is essentially the amount you have paid into the contract through premiums, but it can get more complicated than that. Let's say you've paid in $40,000 over the years, have not had any events that deplete your basis (such as dividends received in cash) and you want to withdraw $10,000 from your cash value. If your contract is not a MEC then it would generally not create a taxable event, assuming your contract meets certain requirements. With non-MEC contracts, you can draw from the policy on a first-in, first-out (FIFO) basis, enabling you to access the basis without immediate taxation. However, it's crucial to monitor your cash value so the death benefit for the contract remains in force for as long as you need it. Loans and withdrawals can potentially cause the contract to lapse. If a contract lapses or is surrendered with an outstanding loan, a tax may result. Additionally, any unpaid loan balances will result in a smaller death benefit.

Once your withdrawals (other than loans) exceed your basis, the excess amount is generally treated as income. As a result, that income could be taxable, and you might owe additional tax penalties as a result of your distributions.

Surrendering a contract or canceling your coverage is similar. When the proceeds exceed your payments, you could have taxable income.

Some contracts can pay dividends to contract owners, which are known as participating policies. Those dividends are not guaranteed, and they depend on the insurer's financial performance, claims experience compared to expectations and expenses to do business, but they may be an excellent benefit for contract owners.

Dividends are generally considered to be distributions which reduce the basis in your contract and may become taxable. Taxation of dividends happens most often when dividends are taken in cash. Tax will apply right away on cash dividends taken from MECs with gain. And, similar to withdrawals, if the dividend payments on non-MECs exceed your basis then any subsequent dividends will create taxable income.

Dividends that are put back into the contract to pay premiums or purchase paid-up additions increase the contract's cost basis when they go back in and as a result they are less likely to result in future tax. Additionally, if you choose to leave dividends with an insurer to generate interest income, the interest may also be taxable.

Dividend payments could eventually become taxable. In most cases, a death benefit paid directly to an individual is not included in the recipient's income.

Employers can pay group term insurance premiums on coverage up to $50,000 with no tax consequences for the employees. When employers provide coverage above that level, there might be income tax implications—unless you pay the premiums for additional insurance yourself. That said, the death benefit should still be income tax-free to a designated beneficiary, even when coverage exceeds $50,000.

Life insurance can be an effective way to protect loved ones or provide substantial assets to the next generation. In many cases, death benefits are not subject to income tax, which enhances the value of those benefits. Moreover, it may be possible to access the cash value from permanent life insurance while you're alive without taxation.

That said, it's good to be aware of the exceptions that can trigger taxes. Consider your needs and goals, and speak with a financial advisor to explore the possibilities. You might learn about different ways to manage your assets and provide for your family using life insurance and other tools.