Is Life Insurance Taxable?

When a loved one passes, you’ve often got a lot of details to handle on top of dealing with grief. One of those details may be figuring out how to access a life insurance policy the deceased left behind, from how to file a claim to whether that insurance will involve a tax burden.

We’ll explain the general guideline about whether you should expect to pay taxes on life insurance benefits and then we will share exceptions to the guideline.

Do you have to pay taxes on life insurance?

In most cases, a death benefit received by a beneficiary is not considered taxable income—the death benefit is generally received free of income tax (both at the federal and state levels). However, there are a few exceptions that could affect a small number of people. We’ll go through the most common exceptions—first, for beneficiaries receiving proceeds after the death of a loved one. Then, we’ll share some situations affecting policyowners when the insured person is still alive.

If the death benefit earned interest

If the death benefit is not immediately paid out, it’s earning interest. That interest is taxable income. The beneficiary may owe taxes on the interest accumulated from the date of death until the claim is settled (but not on the death benefit itself).

If the beneficiary receives the death benefit in installments

Sometimes a beneficiary chooses to receive the death benefit payment over a period of several years, sometimes called “installments.” The beneficiary may owe federal and/or state income tax on a portion of each payment.

If the policyowner accesses the death benefit early

If the insured person is living with a terminal illness diagnosis or meets certain conditions, some policies allow for an acceleration of death benefit. Taxation of these benefits varies depending on the specific circumstances and applicable tax laws. If you’re receiving such benefits, a tax professional can help you understand what you’re responsible for.

Generally, if the policyowner surrenders or cancels the policy, any cash value received above the policyowner’s premiums paid is subject to income taxation.

If the policyowner borrowed against the cash value

While they’re living, the policyowner may be able to borrow against the cash value of a policy. Usually the amount borrowed is not taxable unless the policy lapses or is surrendered without repayment of the loan.

Withdrawals, loans and assignments of a life insurance policy which is a Modified Endowment Contract (MEC) are income taxable to the extent of the gain in the policy. A 10 percent penalty may also apply to a MEC.

If the policy is part of the policyowner’s estate

If the insured designates their estate as the beneficiary, everything paid to the estate—including cash and securities, real estate, annuities, business interests and the life insurance proceeds—could be subject to estate tax. If the insured owns a policy on their own life or has an incident of ownership, the death benefit is included in their taxable estate, regardless of the beneficiary designation. If the total of the assets included in the taxable estate exceeds the threshold set by Congress, estate taxes may apply.

Most people are not wealthy enough to meet the threshold (in 2024 it is $13,610,000 per individual). Even if they do have significant wealth, only the amount above the threshold is taxed. Keep in mind that states may also impose their own tax.

Another exception to the guideline is that all or a portion of the death benefit may be taxed as income if the policy is owned by a qualified retirement plan or was ever transferred in exchange for valuable consideration. If you’d like to check on the taxability of a life insurance policy payout, you can use an online tool from the IRS or consult with a tax professional.

Is the cash value of life insurance taxable?

If you own a permanent life insurance policy, it’ll grow cash value over time. Once you have enough cash value, you can access it for added financial flexibility. While accessing cash value will reduce death benefit, this can become a versatile source of funding throughout your life.

The good news is cash value grows tax-deferred. But just like with a life insurance death benefit, there are some exceptions when you would need to pay tax on it. You may have to pay income tax on a portion of the cash value if:

• The policy is surrendered; or
• The policy terminates before you’ve repaid a loan you took against the policy; or
• You withdraw the cash value and take more than the amount of premium you’ve paid into the policy; or
• The cash value is withdrawn, assigned or borrowed against for a policy classified as a Modified Endowment Contract (MEC).

Is life insurance tax deductible?

Life insurance premiums paid by individuals are not tax deductible. The one exception applies to a business paying premiums for policies owned by its employees. The business may be able to deduct the premium as reasonable compensation but the employee reports that premium as taxable income.

How do I minimize taxes on life insurance proceeds?

If you’re concerned your life insurance policy may be subject to tax, there are some actions your financial advisor can explain to you that could reduce the impact of taxes on your benefit. For example, establishing an irrevocable life insurance trust could allow you to make the trust the owner and beneficiary of the policy and exclude the death benefit from your taxable estate. Remember that, for most people, taxes on a life insurance benefit shouldn’t be an area of concern.

The best way to be prepared for taxes is to work with a financial advisor and tax professional to know what you’re up against. A Northwestern Mutual financial advisor, together with your tax professional, can help you understand the ins and outs of your specific situation and empower you to make the best decision.

Consult with a tax professional to fully understand the tax implications of life insurance for your circumstances.