For many, one of the most important financial tools to prepare for and secure long-term financial plans is life insurance. Life insurance is a financial product meant to transfer the risk of death from the policyholder to the policy provider. It usually works by having the policyholder make premium payments in exchange for a death benefit, typically paid to beneficiaries upon the insured's death.

Your beneficiaries may depend on this benefit for their financial needs, so you might be wondering how much they get to keep after taxes. The good news is that, in most cases, money paid out from a life insurance policy is not taxable. But, there are some exceptions.

Are there exceptions to not paying taxes on life insurance?

Some exceptions exist for when life insurance payouts might be subject to taxation. One such instance occurs in the event that the contract changes ownership (through a sale or disposition) for cash or other valuable consideration. In other words, the policy is sold from one party to another.

In the situation where you buy an existing policy from someone else, you can exclude what you paid (purchase price) and any additional premiums you pay after the purchase. This is called the transfer-for-value rule.

For example,

  • if you purchased an existing $100,000 policy for $30,000 from an insured person and
  • paid $40,000 in premiums before the insured passes away (triggering the payout),
  • you could exclude $70,000 of the proceeds from your income ($30,000 + $40,000 already paid).

It should be noted that certain exceptions exist to this rule. In general terms, you should reference forms such as Form 1099-INT or Form 1099-R that you receive to report the taxable amount. For additional information on this situation, see IRS Publication 525, or read more about taxable and nontaxable income.

Are life insurance payouts included in your estate?

Aside from the situation described above, life insurance death benefits are potentially subject to taxation in two more situations:

  1. The death benefit is paid to the estate of the insured. In this situation, the entire insurance payout is typically included in the estate and can be subject to estate taxes.
  2. The deceased person owns the policy on the date of death. If the deceased person owns the policy at the time of death, then the proceeds from the policy can be subject to estate taxes.

For the first scenario, most people opt to name individuals (other than themselves) as beneficiaries. Doing so avoids having the payout go to an estate. For the second, having a different person or entity such as a Life Insurance Trust own the policy can keep it out of the deceased’s estate.

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Does timing matter for transferring a policy in terms of taxability?

When faced with the decision of transferring a life insurance policy, the timing matters. In the event that you transfer an insurance policy and die within the following three years, the policy will still likely be included in your estate. Therefore, if you have a fear of poor health shortening your lifespan, you might opt to transfer this policy sooner rather than later should you wish to avoid the tax consequences.

Are life insurance policy loans taxable?

In some cases, you might find the need to borrow against the value of your life insurance policy. To determine whether this registers as a taxable event, you will need to figure out how the amount borrowed relates to the premiums you have paid on the policy. Specifically, the money borrowed against the insurance policy does not incur a taxable consequence so long as it is equal to or less than the sum of the insurance premiums you have paid on the policy.

On the other hand, you will have a taxable amount equal to the size of gain you realize, which equals any amount you received from the cash value of your policy minus the net premium cost. This would normally be equal to the amount of premiums paid less any distributions you have received.

For example, imagine you carry a life insurance policy with

  • a death benefit of $500,000,
  • with $100,000 in premiums paid to date and
  • a policy loan of $200,000 without any distributions.

In the event your policy lapses, you will need to claim $100,000 as taxable income ($200,000 loan – $100,000 premiums paid).