Are Life Insurance Proceeds Taxable?
This is a common question that comes up if you've recently received a life insurance payout or are thinking about cashing out your policy. If you're named the beneficiary of a life insurance policy, there are federal and state income tax and estate tax issues that could arise.
Generally speaking, if you received a payout due to the insured's death, what you receive is not taxable.1 There are some exceptions, however.
We'll discuss those, along with other common situations where life insurance proceeds could impact your taxes.
Interest on Delayed or Periodic Death Benefits
For many life insurance policies, death benefits are distributed immediately. That means there is no impact on the beneficiaries' income taxes. However, some life insurance beneficiaries opt to have the proceeds held for a certain amount of time, such as six months or a year. This helps minimize conflict in the estate administration process.
It can also produce a significant amount of taxable interest. The beneficiary would receive a report of that taxable interest on a Form 1099-INT.2 If life insurance proceeds are paid to the beneficiary periodically in installments, there may also be taxable interest.
Interest is also considered investment income. This affects what the life insurance beneficiary may owe on the Net Investment Income Tax,3 as well as their eligibility for the earned income tax credit.4
The Net Investment Income Tax is a tax that applies to investment income of individuals that exceeds threshold amounts. The earned income tax credit is a potential tax reduction and refund for individuals with low income.
Life insurance interest that's received can affect both, but only the interest received on the life insurance benefits is taxable.
Early Surrender of Whole Life Insurance
If you have term life insurance and cancel your contract, there are no tax consequences. You haven't built up cash value, so there isn't anything to tax.
But if a permanent life insurance policy is cancelled prior to you passing on, you could receive the entire cash value back depending on the carriers cancellation policy. That additional income would be taxable.
For instance, if $10,000 in premiums was paid over the years that a permanent life insurance policy was in effect, and it resulted in $30,000 in proceeds, then $20,000 would be taxable. The $30,000 will be reported on a Form 1099-R,5 with the $20,000 taxable portion shown separately.
Accelerated Death Benefits and Terminal or Chronic Illness
You may be able to arrange accelerated death benefits with your insurance provider if you are chronically or terminally ill and need to access your benefits now. The acceleration of life insurance policies do not create taxable income.
If you terminate your policy for any other reason, such as financial hardship or you need startup funds for a business, then the income in excess of premiums paid is taxed.
Life Insurance and the Estate Tax
In addition to income tax issues, there may be estate tax considerations for life insurance proceeds. If a beneficiary was not named, or if the primary beneficiary passed on before the insured and no new beneficiaries were named, the life insurance proceeds will go to the insured's estate.
A federal estate tax return is required if the gross estate is worth more than $11,180,000 if the policyholder died in 2018.
Not all states have their own estate tax. Of the ones that do, the minimum filing threshold could be significantly lower than the federal threshold. Life insurance proceeds may require state tax payments at the estate level.
Under most circumstances, the life insurance death benefit proceeds do not create federal taxable income. However, if you surrender a life insurance policy for reasons other than chronic or terminal illness (as defined by the Internal Revenue Code), you may face tax consequences.
Protecting your greatest asset... Peace of Mind
Federal estate taxes are generally due within nine months of death and could absorb nearly half of your assets before a single dollar goes to your heirs.6 Using Universal Life Insurance for estate planning may let you plan ahead to help provide funds for taxes and settlement costs. For example, American General Life Insurance Company offers a policy, known as Second to Die, that covers both you and your spouse and the benefits are paid on the second death - when your estate passes to your heirs and estate taxes are generally due.
Flexibility for Today and Tomorrow
Life insurance for estate planning can offer these, and other, benefits:
- No-Lapse Guarantee - the policy is guaranteed to remain in force regardless of its cash value, as long as the cumulative monthly guarantee premium requirement is met. If the younger insured is under 50 years old at the time of issue, guaranteed coverage will last 50 years; if he or she is 50 or older, the guarantee will last to age 100.
- Premium Payment Options - You can select a payment plan that fits your financial needs and goals. Pay the guarantee premium for lifetime security, pay less than the guarantee and catch up later, or contribute additional funds to accelerate the growth of your cash values.
- Flexible Death Benefit - Increase or decrease your death benefit to fit your changing needs.7
- Zero-Interest Catch Up - You don't necessarily need to pay the monthly guarantee premium from day one. You can start with a lower premium and catch up the unpaid difference at any time - without interest - as long as the policy is in force.
Disclosure: This information is general in nature, may be subject to change and does not constitute legal, tax or accounting advice from any company, its employees, financial professionals or other representatives. Applicable laws and regulations are complex and subject to change. Any tax statements in this material are not intended to suggest the avoidance of U.S. federal, state or local tax penalties. For advice concerning your situation, consult your professional attorney, tax advisor or accountant.
6. Consult with your tax professional to determine the effect of federal estate taxes on your individual situation.
7. Increases and decreases are subject to the policy's terms and conditions.