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 a named beneficiary or a life insurance owner planning to make a withdrawal on your 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.1 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 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.
The taxable interest a beneficiary may receive associated with delayed receipt of death benefits may be considered investment income and impact the beneficiary's Net Investment Income Tax. Beneficiaries should consult with their tax or legal advisors for their specific impact.
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 carrier's 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. The taxable amount would include the amount received that is greater than the tax basis in the policy.
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,3 with the $20,000 taxable portion shown.
Accelerated Death Benefits and Terminal or Chronic Illness
You may be able to receive accelerated death benefits if you are chronically or terminally ill and need to access your benefits. These amounts may be excludable from taxable income. However, there are certain limitations that should be discussed with your tax or legal advisors.
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 contingent beneficiaries were named, the life insurance proceeds will go to the insured's estate.
Disclosure: This material is general in nature, was developed for educational use only, and is not intended to provide financial, legal, fiduciary, accounting or tax advice, nor is it intended to make any recommendations. Applicable laws and regulations are complex and subject to change. Please consult with your financial professional regarding your situation. For legal, accounting or tax advice consult the appropriate professional.
1. Death Benefits are generally excludable from the beneficiary’s federal taxable income under most circumstances and under current federal income tax law. You should consult your tax advisors for your specific factual situation
2. https://www.irs.gov/forms-pubs/about-form-1099-int
3. https://www.irs.gov/forms-pubs/about-form-1099-r
