Is life insurance taxable?

Do beneficiaries pay taxes on life insurance proceeds?

If you’ve just received a sum of money from a life insurance policy, you usually don’t have to worry about federal income taxes. In most cases, the death benefit of a life insurance policy is not considered taxable income. This is true of all forms of life policies, and it helps ensure that the financial support reaches the beneficiaries as the policy owner intended. However, it is important to go over your situation with a trusted financial advisor or tax professional.

Types of life insurance taxes

When discussing life insurance and estate planning, there are three primary types of taxes that can come into play. They are:

Income taxes

As mentioned, generally, life insurance benefits are not subject to federal income taxes. However, there are some situations in which taxes may be charged, both while the policy owner is alive and after the insured person’s death. We will cover the different scenarios in the next section.

Estate taxes

These taxes apply to the overall value of an estate before it passes to heirs. Life insurance proceeds can be included in an estate's value if the life insurance policy is not structured correctly. If the estate surpasses the exemption limit in the year that the insured passes away, this can lead to significant taxes, particularly for policies with sizable death benefits. For an individual, the exemption limit is set at $13.61 million for 2024.¹

Inheritance taxes

This tax is different from estate taxes and applies only to residents of a few states—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Inheritance taxes can be avoided in some situations, but rules vary from state to state.

When is life insurance taxable?

Before you make any decisions that could affect your tax burden, you should consult a tax professional to understand what may or may not be applicable to your unique situation. That said, here are the most common ways life insurance can increase your taxes:

If there are more than two parties involved

Every life insurance policy has three key roles:

• Insured — The person who is covered by the policy.
• Policy owner — The person who owns (and usually pays for) the policy.
• Beneficiary — The named person(s) who will receive the death benefit.

Usually, the policy owner and the insured are the same person, but that isn’t always the case. Sometimes the policy owner is the beneficiary. This is the case if the policy owner insures a spouse or a child. In other circumstances, all three roles may be different people. If that is the case, a gift tax may apply to the proceeds if they exceed certain limits.

If you withdraw funds from the cash value of a policy

Some policies, like whole life and universal life, can accumulate cash value. That cash value grows tax deferred over time, and you can make withdrawals from it or take a loan out against it tax free. However, certain tax advantages are no longer applicable to a life insurance policy if too much money is put into the policy during its first seven years, or during the seven year period after a “material change” to the policy.^*

If your death benefit goes to your estate

If you name your estate as your beneficiary, there are a couple of ways the proceeds can be reduced. First, your estate may be subject to the probate process, and if there are debts, they will need to be paid off (from the death benefit, if necessary) before the money can be dispersed to heirs. That could reduce the amount your heirs collect. Second, if the value of your estate is above the exemption limit for estate taxes, it will increase your estate’s value, which might lead to higher estate taxes.

If you surrender your policy

If you no longer need your whole life policy, you have the option to surrender it to the insurance company, often in exchange for a cash payment based on the accumulated cash value within the policy. This can lead to taxes and penalties on the accumulated cash value if it exceeds the premiums paid.

If you sell your policy

Sometimes people choose to sell their life insurance policy to a third party instead of surrendering it. If you choose to go this route, any profit you make, after accounting for your cumulative premium payments, could be taxable as income.

Can I avoid estate taxes with an irrevocable life insurance trust (ILIT)?

An irrevocable life insurance trust is a legal arrangement designed to hold and manage life insurance policies outside of the insured individual's estate. By removing the life insurance policy from the grantor's estate, the value of the policy is excluded from the calculation of estate taxes. This can be beneficial for families with considerable wealth. Here's a brief overview of how an ILIT works:

1. Establishing the trust: The policy owner (grantor) creates the trust and can place a life insurance policy within it two ways. They can either transfer ownership of an existing policy to the trust or the trust can apply for a new policy. The second option is often advised, since transferring an existing policy can cause it to revert back to the estate if the insured passes away within three years of the gift. 
2. Appointing a trustee: The grantor selects a separate trustee to manage the ILIT. The trustee is responsible for overseeing the trust's administration according to the grantor's wishes.
3. Naming beneficiaries: The ILIT names specific beneficiaries who will receive the proceeds of the life insurance policy upon the grantor's death.
4. Funding the trust: The grantor can make annual gifts to the trust, which are then used to pay the life insurance premiums. If properly structured, these gifts can qualify for the annual gift tax exclusion, allowing the grantor to contribute to the trust without triggering gift-tax implications.
5. Establishing irrevocability: Once the policy is transferred to the trust, it cannot be changed by the grantor without the consent of the beneficiaries and/or trustee. This irrevocability is a key aspect that helps ensure the policy remains outside the grantor's estate.

If you would like guidance on how to structure your life insurance to best benefit your family or if you want to explore options for an irrevocable life insurance trust, a New York Life agent can help walk you through your options. In addition, you should always consult a tax professional for tax advice.

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¹“Estate Tax,” IRS.gov, October 2022.

*If the cumulative premiums paid during the applicable 7-year period at any time exceed the limits imposed under the Internal Revenue Code, the policy becomes a “Modified Endowment Contract” or MEC. A MEC is still a life insurance policy, and death benefits continue to be tax free, but any time you take a withdrawal from a MEC (including a policy loan), the withdrawal is treated as taxable income to the extent there is gain in the policy. In addition, if you are under 59 ½, a penalty tax of 10% could be assessed on those amounts and upon surrender of the policy.