Taxes on life insurance: Here’s when proceeds are taxable

Fact-checked with HomeInsurance.com

3 min read
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Most people with families are aware of the importance of life insurance — the proceeds can help your surviving spouse and dependents support themselves if you pass away. But life insurance is a smart decision, even if you’re single. If something happens to you, life insurance will help your loved ones pay for your funeral expenses, as well as any debts you leave behind.

Most people choose life insurance to protect their loved ones and leave them in a better financial place. But will the recipients of the policy be stuck with a tax liability?

Are life insurance proceeds taxable?

If you’re wondering if your loved ones will get the full amount of the policy, you can rest assured that in most cases, the beneficiaries will get the full amount you’ve underwritten. Life insurance proceeds aren’t taxable. If you’re the beneficiary of a life insurance policy, the IRS says you don’t have to report the amount received as income when you file taxes.

There are some exceptions when you may have to pay tax:

When the payout comes in installments instead of a lump sum

There are two ways the benefit can be paid — as a single lump sum or in installments. Some people prefer to receive money over time to avoid spending the full amount. But they should be aware that the interest is taxable.

Jonathan Holloway, co-founder of NoExam.com, a digital life insurance brokerage explains, “If the payout is paid in installments, the interest that accrues on the payouts is taxable. The death benefit is not taxable, only the interest on installments.”

If the beneficiary is an estate

If the policyholder decides to name an estate instead of an individual as the beneficiary, the process gets more complicated. If the death benefit pushes the estate’s value over $11,580,000, your beneficiaries will have to file an estate tax return. Leaving the proceeds to an estate adds to its value, which could lead to higher estate taxes for your heirs.

When you leave a cash value policy

This one may not be a taxable issue but still affects the beneficiary. The policy owner can borrow against the funds in a cash value policy. If you borrow against your policy and don’t pay it back, the insurance company will deduct what you owe before they pay out the death benefit.

What should you do with life insurance proceeds?

There is no set rule about what you should do with your life insurance proceeds. It may be tempting to go on a spending spree when you first receive the money, but putting off spending for a while and consulting with a financial advisor may be a wise choice.

Thomas D. Currey, owner of TDC Financial Services in Grand Prairie, Texas, and chair of the board of directors of the nonprofit Life Happens, warns individuals to be careful with their newly acquired windfall. “The one word of caution I’d have is that when anyone comes into a large sum of money, it’s easy to spend first and ask questions later,” Currey says. “Seeking counsel to help you assess what your current needs are and how to make it go as far as possible is always a good idea.”

You already know the scenarios that answer the question “is life insurance taxable?” As for what to do with the death benefit, here are some ideas:

Pay off high-interest debt

If you have credit card debt or you’re paying off student or personal loans with high-interest rates, paying off the debt can save you money on the interest you’re paying.

Set money aside for your children’s education

Create a college fund for your kids by putting some money into a 529 college savings plan. The funds can be withdrawn tax-free to pay for qualified school expenses.

Create an emergency fund

If you’re living from paycheck to paycheck, an emergency fund could take some of the pressure off. You should have between three and six months worth of living expenses in your emergency fund to cover your cost of living if you lose your job, your car breaks down or you become ill and unable to work.

Frequently asked questions

Is life insurance taxable if you cash it in?

In most cases, your beneficiary won’t have to pay taxes on the death benefit. But if you want to cash in your policy, it may be taxable. If you have a cash-value policy, withdrawing more than your basis (the money it’s gained) is taxable as ordinary income. It’s best to check with your provider before you cash in — some policies state cash withdrawals made in the first 15 years are taxable.

Do you get a 1099 for life insurance proceeds?

You won’t receive a 1099 for life insurance proceeds because the IRS doesn’t consider the death benefit to count as income.

Are life insurance premiums tax deductible?

Premiums are not deductible unless they are paid to someone else, for example, as part of an alimony agreement.