Do You Pay Taxes on Life Insurance?

♦ 04/25/2024 ♦ Leave a comment

Owning a life insurance policy can be an effective way to ensure that your loved ones are provided for if you die prematurely, and it can also play an important role in estate planning. But do you pay taxes on life insurance? Whether the policy proceeds might be subject to income taxes or estate taxes depends on how the policy is owned and how the beneficiary is named.

Types of Life Insurance

Life insurance comes in two forms:

  • Term life: Stays in effect for a specific period of time.
  • Permanent life: Remains in effect for the insured individual’s entire life.

With term insurance, you pay premiums on the policy, and if the policy is still in force at your death, the beneficiary of your choice collects the death benefit. One of the benefits of term life insurance is that the premiums are low compared to the financial hardship on your family if you were to die unexpectedly. This is especially true for younger policyholders.

With permanent insurance, such as whole life, you pay significantly more compared to a term policy, but it can be a good choice for high-net-worth individuals who want to preserve their wealth for future generations.

Do You Pay Taxes on Life Insurance?

The general rule is that life insurance beneficiaries don’t have to report policy proceeds as taxable income. For example, if you purchase a life insurance policy and name your spouse as the beneficiary, and your spouse receives the payout upon your death, he or she does not include the proceeds as taxable income on his or her tax return. But there are a few situations where the death benefit is taxable.

Exceptions to Income-Tax-Free Proceeds

Two important caveats exist for the general rule that life insurance proceeds won’t be taxed. The first caveat is that any interest paid on life insurance benefits counts as taxable interest. For example, if the decedent died on Feb. 1 but the proceeds weren’t paid to the beneficiary until March 1, the life insurance company pays the beneficiary the proceeds plus one month’s worth of interest. The beneficiary pays tax on that interest.

The second caveat comes into play if the beneficiary purchased the life insurance policy from the original owner. In that case, the proceeds are generally taxable to the extent they exceed the amount paid for the policy, including additional premium payments made after the purchase. For example, if you purchased a policy from another person for $20,000, paid an additional $5,000 in premiums, and then received a $60,000 payout, you would recognize $35,000 in taxable income — the payout less the $25,000 you paid.

Do You Get a 1099 for Life Insurance Proceeds?

The death benefit you receive as a beneficiary does not count as taxable income, so the insurance company doesn’t report the payment to the IRS. Therefore, it won’t file a 1099. However, you will receive a 1099 form if you were paid interest. Interest is taxable income, and it’s reported on Form 1099-INT.

Estate Tax Implications

Life insurance proceeds might be included in your taxable estate upon your death if:

  • You own the policy
  • The proceeds are payable to your estate
  • You had any incidents of ownership in the policy

Incidents of ownership include the right to change the ownership of the policy, change or cancel the policy, or change the beneficiary of the policy. But the federal estate tax exemption is currently $12.92 million per person for 2023 and $13.61 million per person for 2024, so very few people will have to worry about owing estate taxes.

In the event you do have a taxable estate, consider putting the policy into an irrevocable life insurance trust. This will transfer ownership of the policy and remove it from your estate. However, the transfer must occur at least three years before your death, and you can’t have had any other incidents of ownership within that three-year period — otherwise, the trust remains in your estate and is subject to estate tax if the value of the estate exceeds the exclusion threshold. Current estate tax rates range from 18% to 40%.

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