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Is Life Insurance Taxable?

At Aflac, we issue thousands of life insurance policies every year. We know all the common questions about life insurance, including how life insurance premiums and payouts work with taxes. In most cases there is not a tax on life insurance payouts.1 However, we advise you to speak with a tax professional to ensure that all your bases are covered. There are some instances where the beneficiary can be taxed. Most commonly, the cash value of life insurance is taxable when the inheritance is a particularly large sum.

Life Insurance Tax Types

There are certain instances when your life insurance payout is taxable. To protect your policy, below is a list of different life insurance tax types:

  • Estate Tax: An estate tax is a tax on your right to transfer property upon your death. Your life insurance proceeds may be taxable if your estate is worth more than the maximum threshold allowed.
  • Inheritance Tax: The inheritance tax is a tax placed upon the recipient for any inherited cash payouts, properties, and other assets. Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania are currently the only states that enforce this tax.
  • Income tax: An income tax is collected by the government for any money earned by citizens throughout the year. Typically, life insurance proceeds are not considered taxable income.
  • Generation-Skipping Tax: Similarly to the estate tax, the generation-skipping tax is imposed on any assets that skip a generation. They are only enforced when they exceed the same threshold.

When Do You Pay Taxes on Life Insurance?

There are only certain cases when you have to pay taxes on life insurance. Most notably, if the cash value of the policy exceeds a certain amount you may encounter the estate tax or the generation-skipping tax. The inheritance tax may come into play if you live in one the six states that enforce this measure. Each state has its own set of guidelines regarding taxes on life insurance policies.

When There Are More Than Two Parties Involved

The main parties involved in determining if your life insurance premium is taxable are the policy owner, the beneficiary, and the insured person. Usually, the policy owner and the insured person are one and the same. If this is the case, the policy is not taxable.

However, if a third person is involved, the beneficiary on the life insurance policy may be taxed. For example, say a mother buys her daughter a life insurance policy but names the father the beneficiary. In this instance, the father would be taxed.

When You Withdraw Money from a Cash Value Life Insurance Policy

When you invest in a cash value life insurance policy, part of your premium supports your loved ones and part is invested into an account to help replace lost income. You pay into it throughout your lifetime. To access this money early, you can take out a loan or a partial withdrawal.

If you take out a loan against the cash value, you can be subjected to interest payments and your benefits may shrink over time. If you opt for a partial withdrawal, you may have to surrender the policy to use the money freely. If not, that amount will be subtracted from your final life insurance payout. You shouldn’t pay taxes on life insurance cash outs that are less than what you have paid into your premium.

When You Sell a Life Insurance Policy

You can sell your life insurance policy for cash. However, the broker that facilitates this sale usually takes a portion of the selling price. If the profits are worth more than what you have paid so far, this life insurance payout can qualify for income taxing.

Viatical Settlements for the terminally ill can escape this tax. A viatical settlement allows you to invest in and purchase a life insurance policy that is worth less than the death benefit. It always falls back on how much the policy is being sold for compared to how much has been paid into it.

When You Surrender a Life Insurance Policy

When surrendering a life insurance policy, you may face surrendering fees. You will have to pay taxes on the life insurance cash value because it now falls under the qualifications to be income taxed.

When Your Life Insurance Policy Goes into a Taxable Estate

If the beneficiary isn’t named in your policy, your life insurance benefits will go into a taxable estate. The first $11.7 million is not taxed at a federal level – this is the threshold. Anything above this amount is subject to being taxed. State regulations have a lower chance of exemption and vary depending on location.

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How to Avoid Paying Life Insurance Tax

We recommend you choose your beneficiary wisely. Making the beneficiary “payable to my estate” is one of the most common mistakes. This can raise the value of the estate above the threshold, making taxes more likely. If you name a person, there is a less likely chance of being taxed.

We recommend you consult with a tax professional to help you lower your tax liability. However, one of the main ways to remain protected is to name the beneficiary as an irrevocable life insurance trust. This keeps the cash value away from being lumped into the estate value. In this case, the value of the life insurance policy can be distributed amongst any beneficiaries listed in the trust. This option may shield beneficiaries from paying taxes on life insurance.

Is Life Insurance Tax Deductible?

Typically, life insurance premiums are considered a personal expense. Because of this, life insurance premiums are not tax deductible. However, there are a variety of tax benefits to having life insurance.

There are deductions if you are a business owner, and you have business-paid premiums. Also, the tax deferred cash growth of the policy is not subject to taxing through government regulation either.

This means the cash value of your life insurance plan cannot be taxed while it is growing. This allows you to collect higher interest rates and avoid money being taken out.

Aflac Can Help Answer Your Tax on Life Insurance Payout Questions

If you are curious how to protect your life insurance policy from being taxed, we advise you to speak to a local tax professional and chat with an Aflac agent about your life insurance policies.

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