Are Life Insurance Proceeds Taxable? A Complete Guide

If you have the great fortune of holding down a job with fringe benefits like paid sick time and vacation, and health coverage through dental, vision and health insurance, you might also carry another benefit: group-term life insurance. Most employers who offer fringe benefits with this option usually provide discounted coverage through a partnering insurer as a baseline and then the add-on possibility of carrying more to suit your needs. Further, options exist for purchasing your own life insurance policies directly through life insurance companies. While insurance through your employer or also through your own policy purchased directly through an insurer provides for better financial security, Uncle Sam also has a vested interest in taking his fair share of any such benefit. And if you paid taxes on the front end for this benefit, it begs the question “are life insurance proceeds taxable?” To illustrate, as a general rule, anything an employee receives from an employer as compensation for services rendered – including fringe benefits of the likes mentioned above – counts toward their gross income under the Internal Revenue Code (IRC, section 61), unless specifically excluded by some other section. In this case, IRC Section 79 provides such an exclusion, as discussed in more detail below.

Is Life Insurance Taxable?

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What is Life Insurance?

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Insurance seeks to transfer risk from yourself to another party through the exchange of a stream of payments (premiums) for a lump-sum (or guaranteed stream of payments) at some point in the future. People who purchase life insurance pay premiums in exchange for receiving a death benefit to assist their beneficiaries with financial resources. To understand how much coverage you carry on your policy, check out the insurance declaration page and identify whether you have relevant insurance riders and endorsements. Life insurance comes in many different forms:

• Term life insurance
• Whole life insurance
• Permanent life insurance
• Universal life insurance
• Variable life insurance
• Variable universal life insurance
• Simplified issue life insurance
• Guaranteed issue life insurance

While all vary in form and structure, the primary idea behind life insurance includes the transfer of risk from the insured to the insurer through a life insurance contract. Several people carry life insurance coverage directly through their employers but options also exist for purchasing your own life insurance policies directly through companies like Fabric and Haven Life. Both of these companies allow for online life insurance applications and can have policies approved in minutes in some instances.  Additionally, they offer online will services which can complete some significant steps toward planning your estate. My personal recommendation comes from Fabric, a company which boasts the greatest number of high-rated customer reviews from TrustPilot.

Fabric | Insurance for Families

FABRIC AT A GLANCE

• Online application and policy origination process with potential for medical exam
• Sells term life insurance (Fabric Premium), accidental death (Fabric Instant) policies
• Coverage up to $5,000,000
• 10, 15 and 20 year terms available
• Premium covers any age while Instant covers up to age 60 (if enrolled between ages 25 and 50)

Get Your Free Quote

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What is a Death Benefit?

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The death benefit from a life insurance policy represents the amount paid to the beneficiary of the insured’s life insurance contract.  At the insured’s death, the death benefit transfers to the policy beneficiary/(ies). Alternatively, a death benefit also accrues in the situation of an annuity or pension-holder dying with payments still left on the financial instruments. In other words, the stream of payments received from the annuity or pension-holder’s account will continue (usually in a different amount) to pay after the death of the primary individual. Related: 8 Best Ways to Invest a Lump Sum Life Insurance Payout

Are Life Insurance Proceeds Taxable?

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For all life insurance policies meeting the definition of life insurance, any cash surrender value increases for the policy would not be taxed until received and the death proceeds would avoid taxation. In other words, generally speaking, life insurance proceeds (death benefit) do not have taxes paid against the proceeds. In the event the insured carries a life insurance policy which pays cash dividends (e.g., whole life insurance), these dividends do not count as income on a taxpayer’s return. This passive income receives favorable tax treatment so long as the amount received does not exceed the net premiums paid on the policy. In general, when asking, “is life insurance taxable,” with few exceptions, the answer is almost always no.  However, exceptions exist for when life insurance proceeds are subject to tax.

Which Exceptions Exist for Not Paying Taxes on Life Insurance?

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As alluded to above, some exceptions certainly exist for when your life insurance payout may come into the cross hairs of Uncle Sam. You will encounter one exception when dealing with the transfer of a life insurance contract (through a sale or disposition) for cash or other valuable consideration from one party to another. In other words, when you buy or sell the policy and it transfers ownership from one party to another. When this occurs and you buy the policy from another party, you have the ability to exclude the price you paid as well as any additional premiums you pay toward the policy following the purchase. This exclusion is formalized in the IRS’ transfer-for-value rule. To illustrate this exception, imagine you purchased a $250,000 policy for $60,000 and paid $50,000 in premiums before the insured passes away (triggering the life insurance policy payout), you can exclude $110,000 of the proceeds from your income ($60,000 + $50,000 already paid toward the insurance policy). And not to be outdone, exceptions exist to this exception! In general terms, you would report the taxable amount of the insurance policy based on the type of tax document(s) you receive — such as Form 1099-INT or Form 1099-R, both informational documents provided by the insurance provider or related carrier. To learn more about the finer details of this exception to the exception, see IRS Publication 525. In addition to this exception, two more situations apply where life insurance death benefits fall subject to taxation. Learn more about these circumstances below when the life insurance proceeds have taxable consequences when included as part of your estate.

Are Life Insurance Proceeds Included in Your Estate?

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Before addressing whether life insurance proceeds are taxable to your estate, we first need to address the question of whether life insurance proceeds are included in your estate. Unless otherwise specified, life insurance proceeds are not part of your estate but instead go directly to the policy’s beneficiary and belong to them. This means life insurance proceeds do not need to pass to the estate to satisfy any outstanding debts of the estate.  However, that is unless the deceased makes the poor decision of naming the policy “payable to my estate” as the beneficiary. When you choose to name your estate as the beneficiary, this removes the contractual advantage of naming a real person as beneficiary and then subjects the life insurance proceeds to the probate process, or the “official proving of a will.” This process can be timely and heavily contested, depending on circumstances. Aside from the additional time required to settle the affairs of the estate and distribute the assets in accordance with the wishes of the deceased, the financial repercussion involves increasing the estate’s value, and potentially subjecting your heirs to high estate taxes. Related: What Happens if a Minor is the Beneficiary? [Trusts & Wills]

When are Life Insurance Proceeds Taxable to the Estate?

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Similar to the circumstance described above when the life insurance policy transfers from one owner to another, two scenarios also exist where life insurance payouts become taxable.

1. The life insurance death benefit pays out to the estate of the insured. When this occurs, the entire insurance payout must be included in the estate and becomes subject to estate taxes.
2. The deceased policy owner possessed the policy on the date of death. If the policy holder dies without a designated beneficiary, the insurance proceeds then pay out to the policy owner’s estate.  In this case, the proceeds can become subject one again to estate taxes.

To avoid the first situation from occurring, most people avoid having the policy pay out to the estate and instead name beneficiaries. By doing this, it avoids having the payout go to an estate and become taxable. In the case of the latter situation, by choosing to designate a beneficiary, you can avoid paying estate taxes on the life insurance payout.

Are Life Insurance Proceeds Subject to Creditors?

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In general, when a life insurance policy’s proceeds pay out, these proceeds usually only become taxable (with a few exceptions discussed above) when the policy holder names his or her estate as the beneficiary. In the event the policy holder named another person as the beneficiary, these policy proceeds will be exempt from the policy owner’s creditors unless the death benefit proceeds revert to the deceased’s estate. However, in the event the beneficiary has money owed to creditors, these life insurance proceeds do not automatically become exempt from creditors, unless the state has specific state protection laws in place. If you purchased a term life insurance policy through a company like Fabric and named a beneficiary who is not your estate, a minor, or otherwise disqualified from having these life insurance proceeds avoid taxation, you will not have the proceeds go to a creditor.

Fabric | Insurance for Families

FABRIC AT A GLANCE

• Online application and policy origination process with potential for medical exam
• Sells term life insurance (Fabric Premium), accidental death (Fabric Instant) policies
• Coverage up to $5,000,000
• 10, 15 and 20 year terms available
• Premium covers any age while Instant covers up to age 60 (if enrolled between ages 25 and 50)

Get Your Free Quote

 

What is Cash Surrender Value?

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In insurance, when you voluntarily terminate your policy before its maturity or an insured event occurs in exchange for a discounted payout, you receive the cash surrender value. This represents the sum of money an insurance company pays to the policyholder or an annuity contract holder and amounts to a discounted payout from the full value of the death benefit, in the case of life insurance. In practice, the cash surrender value should asymptotically approach the full expected payout value as the policyholder maintains the policy.  In other words, as more time passes and the insured event nears, the insurer will charge a lower percentage in surrender charges. The insurer calculates the cash surrender value by taking the full cash value payout and deducts the surrender charges, plus any unpaid loan principal or interest on the policy.

Do You Have to Pay Taxes on a Surrendered Life Insurance Policy?

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While you may receive less in value by surrendering the life insurance policy, you will not lose the tax free status of the life insurance proceeds.  Fortunately, the IRS does not assess any tax on the cash value of a policy and when you withdraw money up to your cost basis, this money also avoids taxation. Further, should you opt to take a loan against your life insurance policy, you will not pay taxes on these funds as they do not constitute taxable income.  However, in the event your policy lapses, you must pay income tax on your entire gain related to the life insurance policy.

Are Life Insurance Proceeds Tax Free?

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In most circumstances, life insurance proceeds are tax free.  When you or a beneficiary receives a death benefit related to a life insurance policy, the IRS does not considerable this taxable income. Therefore, these proceeds escape taxation.  However, any interest you receive tied to the life insurance policy is taxable and you should report it as interest received and include this in your taxable income. Another circumstance where you might face tax consequences tied to a life insurance policy comes from the tax treatment of life insurance policy loans. Specifically, the tax treatment depends on whether the contract receives treatment as a modified endowment contract (MEC). Most single premium life insurance policies qualify as MECs.  For those life insurance policies entered into on or after June 21, 1988, which do not meet the seven premium payments test of IRC Section 7702A(b) classify as MECs. Loans which use MECs as collateral (underwrite the loan), have tax repercussions. These loans count as taxable income at the time received to the extent the cash value of the contract immediately before the payment exceeds the investment of the contract. In some instances, these distributions may also face a 10% penalty.

Do You Get a 1099 for Life Insurance Proceeds?

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Because proceeds from life insurance policies generally avoid taxation to the recipient, you will not receive a 1099 unless your life insurance payout counts as a taxable event. In this case, you will receive a Form 1099-MISC and will need to report this on your tax return as taxable income. You will have the information reported on the taxable amount of the policy on a Form 1099-INT, Form 1099-MISC, or Form 1099-R, depending on the type of taxable event.

Are Employer-Paid Life Insurance Proceeds Taxable?

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Generally, life insurance proceeds you receive as a beneficiary due to the death of an insured person do not count as a taxable event. As a result, you do not include these life insurance proceeds, whether paid as an individual or by your employer, in your taxable income. Further, you do not have to report these life insurance proceeds on your tax return.

Are Employer-Paid Life Insurance Premiums Taxable to Employee?

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Per the Internal Revenue Code section 79, an exclusion exists for the first $50,000 of group-term (employer-provided) life insurance coverage provided under a policy carried directly (or indirectly) by an employer. In effect, no tax consequences come into effect if the total amount of insurance coverage provided by an employer does not exceed $50,000. Therefore, for any amount of insurance coverage in excess of $50,000, the employee must include the imputed income (cost) of life insurance coverage above this mark as taxable income (reflected on Form W-2). Further, this taxable income also falls under Medicare and Social Security taxation if within applicable income limits. 1099 contractors will not receive these benefits as they do not qualify as an employee of the company. To calculate the taxable income amount for employer-paid group-term insurance above $50,000, the IRS maintains something called the IRS Premium Table in Publication 15-B.

Carried Directly or Indirectly by the Employer

As stated above, a taxable fringe benefit arises in the event the group-term life insurance coverage exceeds $50,000 and the policy classifies as directly or indirectly carried by the employer. To meet the criteria for carried directly or indirectly by the employer, the life insurance policy must have:

1. The employer pay any cost of life insurance, or
2. The employer arrange for the premium payments and premiums paid by at least one employee subsidize those by at least one other employee (triggering the “straddle” rule)

To understand more about this so-called “straddle” rule, see the Publication 15-B above for the IRS Premium Table rates.  As a note, the determination of whether the premiums charges straddle the costs comes from those tables and not the actual cost. As the employer affects the premium cost through subsidizing and/or redistributing the cost, employees receive a benefit.  Because this counts as a fringe benefit (discussed above), this will count as taxable income for all amounts of coverage exceeding $50,000. The employee must calculate the taxable portion of the premiums for coverage exceeding this cap. As an example, let’s assume your employer covers employees exclusively in the 25 through 29, 30 through 34, and 35 through 39 age brackets with group-term life insurance. In other words, young professionals. The cost per $1,000 of life insurance coverage is $0.06, $0.08, and $0.09, respectively.  Your employer pays the full cost of the life insurance on your behalf as a fringe benefit. Let’s imagine everyone in the first age category is 27, the second is 32, and the third is 37 and each category receives the same life insurance coverage (i.e., category 1 receives $50,000 of life insurance coverage, 2 receives $100,000, and 3 receives $150,000). To calculate the taxable income the employees would claim on their tax returns, the first age category would have the entire benefit excluded as it meets the $50,000 exclusion. For the second category (30 to 34 year olds), they would count $48 of taxable income on their tax return (([$100,000 – $50,000 exclusion] / $1,000) * $0.08 * 12 months). Likewise for the oldest category, they would claim $108 of taxable income (([$150,000 – $50,000 exclusion] / $1,000) * $0.09 * 12 months).

Is Life Insurance Deductible for an S Corp?

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To answer this question, let’s cut to the chase and say it depends.  S Corporations can deduct life insurance premiums if the S corporation does not list itself as a beneficiary.  In this case, the S Corporation can deduct life insurance premiums against its taxable income. Also, the S Corporation will need to file a Form 1120S, also known as an information return.  These forms include a portion which shows how their respective income (loss), deductions and credits pass through to the owners on their individual tax returns.

Is Life Insurance Deductible for an LLC?

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The IRS has different rules in place for S Corps and LLCs with respect to the deductibility of life insurance premiums. While S Corps can deduct life insurance premiums, if the company does not list itself as a beneficiary, LLCs cannot deduct life insurance premiums against its taxable income. The only exceptions occur when you own the LLC and pay the life insurance premiums for employees.  In this situation, you may deduct life insurance premiums.

Are Life Insurance Premiums Deductible for C Corporations?

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For life insurance premiums paid by a C Corporation, companies may deduct them if used as security for a loan, similar to how they would for an individual. However, as a general rule, life insurance premiums, whether paid for by individuals or corporations, cannot be deducted from your taxable income. Because the cash values and death benefit payouts avoid taxation, you cannot write off the premiums paid on your taxes.

If You Need Term Life Insurance

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Now that you know more about the tax implications of life insurance proceeds, you might have interest taking the next step and purchasing a policy for yourself or your loved ones. In recent years, shopping for life insurance has migrated online for many low-cost policies, often negating the need for speaking to an agent/salesperson to get a quote. Because many companies operate in this online space, we have curated a list of top online companies that sell life insurance to save you time and effort in your search for the best quotes. To make this list, the companies included must make shopping for life insurance easy by keeping the process online and quick. And remember, ​getting a quote doesn’t cost you anything! Check out our list below!