It’s wise to consider whether you must pay taxes any time you receive a large sum, as in the case of a life insurance payout. As a life insurance beneficiary, you won’t usually have to pay taxes. There are exceptions, though; you may have to pay estate taxes on the death benefit.
Tax implications of interest income
Anytime there is an accrual of interest, the government taxes it somewhere along the line.
The interest earned on the money is not taxable while the policy is in force. When the insured dies, the policy triggers a benefit payout. While the federal government doesn’t tax life insurance payouts, beneficiaries must pay taxes on any interest the policy earns.
For example, let’s say John’s father passed away, leaving him a $100,000 life insurance policy. The insurance company pays John a $100,000 payout as he is the sole beneficiary. John doesn’t have to pay taxes on this benefit.
A permanent life insurance policy may earn interest on the policy. If Susie’s spouse died, leaving her a $200,000 whole life insurance policy that generated interest at a rate of 5% in the year before it was paid out, she would receive the full death benefit of $200,000 plus $10,000 in interest. Susie would not have to pay taxes on the $200,000, but she would have to pay taxes on the $10,000 that was generated in interest.
If the policy remains with the insurance company after the insured’s death, the interest earned is taxable to the estate.
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Estate and inheritance taxes
| Type of policy with $100,000 death benefit | Amount taxed on death benefit | Amount taxed on interest |
| Term insurance | 0 | Doesn't earn interest |
| Whole life with 5% interest | 0 | $5,000 |
| Whole life with 10% interest | 0 | $10,000 |
While those who receive life insurance payouts don’t usually have to pay taxes on the money, they may still have to pay estate or inheritance taxes. An estate includes everything the deceased person owns or has a financial interest in when they die.
The following items are considered part of a person’s estate:
- Cash
- Securities
- Real estate
- Insurance
- Trusts
- Annuities
- Business interests
People commonly transfer their homes and other assets to their loved ones in their last will. Since the deceased cannot pay taxes on their money, the federal government taxes the receiver of the money.
The federal government instituted the Estate Tax in 1916 so it has a way of taxing the money a person has at the time of their death. Simply put, if the amount of money a person has at the time of their death is more than the amount on the IRS chart, taxes must be paid.
In fairly simple estates that consist of cash, jointly held property, publicly traded securities, and other small amounts of assets, beneficiaries may not have to pay estate taxes. Large, highly valued estates are subject to estate taxes if the net value of the estate is more than the IRS threshold.
| Year of death | If amount described above exceeds |
| 2011 | $5,000,000 |
| 2012 | $5,120,000 |
| 2013 | $5,250,000 |
| 2014 | $5,340,000 |
| 2015 | $5,430,000 |
| 2016 | $5,450,000 |
| 2017 | $5,490,000 |
| 2018 | $11,180,000 |
| 2019 | $11,400,000 |
| 2020 | $11,580,000 |
| 2021 | $11,700,000 |
| 2022 | $12,060,000 |
| 2023 | $12,920,000 |
| 2024 | $13,610,000 |
The IRS’s threshold amount for estate taxes usually changes every year. Due to the Tax Cuts and Jobs Act, the amount increased drastically from $5,490,000 in 2017 to $11,180,00 in 2018 and has risen yearly. This Act will expire at the end of 2025 unless Congress extends it. If they don’t, the exemption will drop to $5,000,000, which will be adjusted for inflation.
The current threshold is $13,600,000 for anyone who dies in 2024. The IRS updates the threshold amount annually and makes the information available to the public.
Potential gift tax considerations
Most life insurance policies are set up so the insured and the policy owner are the same individual. The owner names the beneficiary, and a beneficiary change can occur anytime.
The IRS doesn’t require the beneficiary to pay tax on the payout unless the amount is over the threshold as described above.
It’s also possible for an individual to take out an insurance policy on someone else’s life under the following circumstances:
- The insured must be aware of your decision to buy the policy.
- The insured must agree to your decision to buy the policy.
- You must have a financial interest in them.
Having a financial interest in someone means that you rely on someone’s financial support and you’d suffer in some way if they died. Whenever the owner, insured, and beneficiary are different people, a gift tax may be levied.
Two workarounds to avoid life insurance taxation
Large estates with wealth over the IRS’s stated amount may need to pay taxes on a life insurance policy when the owner dies. To avoid taxation on life insurance in this situation, the owner of the estate has two choices:
- Transfer the ownership
- Set up a life insurance trust
Transferring ownership
To transfer the ownership of a life insurance policy, you will need to contact the insurer and fill out the proper forms. The new owner will need to pay the premium on the policy. The owner will then have all rights to make future policy changes.
Once the policy has been transferred to another individual, it cannot be transferred back to the original policy owner. If a married person transfers the policy to their partner or spouse and the couple later divorces, the new owner bears all the rights and responsibilities of the policy.
This strategy requires some advance planning. If you transfer the policy in the three years before you die, the IRS will still tax the policy.
Using life insurance trusts
The other way to eliminate worry over taxation is to establish an irrevocable life insurance trust. In this situation, the trust becomes the policy owner, and the proceeds won’t become part of the estate. The trust is irrevocable, and you cannot be its trustee.
A benefit of having a trust is that you can ensure the premiums will continue to be paid and the policy will remain in force.
Knowing the IRS rules for taxation will prevent needless worry over taxes on a life insurance policy. The correct information will also allow you to strategize on minimizing taxation. Check out our other articles on life insurance at Healthnews and get personalized advice for your unique circumstances by consulting a financial advisor.
FAQ
Do you have to pay taxes on life insurance?
It depends. You won’t have to pay taxes if you have a term life policy, as it doesn’t accumulate interest. You also won’t have to pay taxes if the life insurance is part of an estate and the total value is less than the IRS’s threshold, which is $13,600,000 in 2024.
Is the cash surrender value of life insurance taxable according to the IRS?
Yes. Any time a fund generates income, the IRS will tax it at some point. Whole life insurance policies accumulate cash value, and you have to pay taxes on the cash value that accumulates over the life of the policy when the insured dies.
Is there a way for a beneficiary to avoid taxes on a life insurance payout?
No. Beneficiaries will have to pay taxes on the interest earned by the policy and there is no way to avoid that. Designated beneficiaries will not have to pay taxes on the death benefit portion of the policy, though.
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The death benefit of a permanent life policy will not be taxed, but beneficiaries will have to pay taxes on the interest earned on the policy.
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Beneficiaries may have to pay taxes on the interest portion of a life insurance policy.
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Beneficiaries of an estate may have to pay estate taxes when the estate owns a policy.
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Transferring the policy to another individual or putting the policy in a trust will help prevent taxation on a life insurance policy that is part of an estate.
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