Do You Pay Taxes on a Life Insurance Payout?
“Will my family have to pay taxes on my life insurance benefits?”
In the majortity of situations, life insurance benefits are received income tax-free, but there are a few exceptions that could create a tax liabilty for your beneficiary.
This insider's guide outlines the cirumstances that could create a tax liabilty on your life insurance benefits. We've also included some information on how you can legally avoid estate or inheritance taxes with life insurance.
Quick Article Guide
Here’s what we'll cover in this post:
- General Taxation of Life Insurance Benefits
- In What Situations Would My Beneficiaries Owe Taxes On My Life Insurance Payout?
- Exception #1 - Taxing Interest Gained On Life Insurance Pay-Outs
- Exception #2 - Businesses Who Write Off the Life Insurance Premiums
- Exception #3 - Estates Worth More Than $12.92 Million
- How Can I Legally Avoid Estate Taxes?
- What If My Estate Is Worth Less Than the Exclusion?
General Taxation of Life Insurance Benefits
The majority of the time a life insurance benefit is paid, it is paid out tax-free.
... but keep in mind there are several types of taxes, including:
- Federal Income tax
- State Income tax
- Estate tax
Turns out, it depends on HOW your beneficiary receives the death benefit (as a lump-sum or as an annuity) and the value of your estate.
Let's take an example...
Life insurance typically pays out as a lump-sum.The amount of the lump-sum that is paid out to the beneficiary is the face amount of the policy, or the total amount of the insurance.
To break it down: if you are insured for a $500,000 dollar policy, your beneficiary will receive $500,000 if you pass away during the life of your policy, and this amount will generally not be taxed as federal or state income.
In What Situations Would My Beneficiaries Owe Taxes On My Life Insurance Payout?
Let's examine a few exceptions to the general rule that life insurance proceeds are tax free.
Exception #1 - Taxing Interest Gained On Life Insurance Pay-Outs
Life insurance can be paid as annual payouts instead of a lump-sum. In this situation, some life insurance companies will pay interest to you while they are holding the balance of the death benefit pay-out.
Interest is considered to be income by the IRS anytime it is earned. If you gain any interest on the payout of your life insurance, this amount is taxable.
This will not decrease the amount that is paid out below the original coverage amount, however, you will only be taxed on the interest earned from this benefit not the benefit itself.
Exception #2 - Businesses Who Write Off the Life Insurance Premiums
Life insurance premiums, if the policy is owned by a business entity, should generally be paid with after tax dollars.If the premiums are deducted, there's a chance that the death benefit will be taxed as income.
A couple situations where life insurance should definitely NOT be deducted are:
- In the case of a business partnership, where one partner takes out a policy on the other
- Taking out a policy on a business owner to secure a loan
Exception #3 - Estates Worth More Than $12.92 Million
Currently for the tax year of 2023, the Federal Estate Tax Exclusion amount is set at $12,920,000.
This means that if you were to pass away and your estate was valued at more than $12,920,000 (assets minus liabilities), your beneficiaries or whomever inherits your estate would owe estate taxes on the value of your estate that exceeds $12,920,000.
Example: If your estate is worth $15,000,000, and you pass away this year, the beneficiaries of your estate would owe taxes on $2,080,000 ($15,00,000-$12,920,000). The current tax rate for estate taxes in 2023 is set at 40% of this number which equates to $832,000.
In other words, $832,000 would need to be paid to the IRS to by your beneficiaries to keep your estate intact.
Note: The estate tax exclusion is doubled in the case of married couples, so they can leave an inheritance of approximately $25.84 million before estate taxes would be due.
Another Note: Just because an estate is not subject to federal estate tax, doesn't mean it won't owe estate tax at the "state" level. Some states have exemption limits as low as only $1 million.
How does This Apply to Life Insurance?
If you own your life insurance policy, the payout from your life insurance is considered to be part of your estate.
Let’s say your estate is worth $12,500,000 and you have 1.5 million in life insurance, your estate would be valued at $14,000,000.
$12,500,000 + $1,500,000 = $14,000,000 (total estate value)
At your passing, your beneficiaries will be taxed the amount of your estate that exceeds the Estate Tax Exclusion amount ($12,920,000). In this situation, the taxable amount is 40% of $1,080,000.
$14,000,000-$12,920,000 = $1,080,000 (total taxable amount)
So technically in this situation, the proceeds of the life insurance would be taxed (estate taxes only, not income tax), and the amount owed would be $432,000.
$1,080,000 X 0.4 (40%) = $432,000 (total amount owed)
How Can I Legally Avoid Estate Taxes?
If you are not listed as the owner of your life insurance policy, it is not part of your estate.
The easiest way to set this up correctly is to transfer the ownership of the policy to a family member.If you are not in direct control of the ownership of the policy, it is not taxable. The downside to this however is that someone else is in control of your policy so you will want to make sure it is someone you trust.
Another way to set up your life insurance to avoid taxes, you will need to set up an irrevocable trust.
The Irrevocable Trust will become the owner of your policy, but once the irrevocable trust becomes the owner of your policy, you will not be able to make any changes to it.
In this situation, you must name a trustee for your irrevocable trust, you cannot be the trustee of your own irrevocable trust. In addition, the irrevocable trust must own the policy from the time it is purchased until you pass.
If you decide to transfer a life insurance policy that you currently have into an irrevocable trust, do not wait. The irrevocable trust must be the owner of your policy for at least 3 years at the time of death to avoid any estate taxes being assessed.
What If My Estate Is Worth Less Than the Exclusion?
Only the amount of your estate that exceeds the Estate Tax Exclusion amount can be taxed, so if your estate including life insurance is not more than $12,920,000, your beneficiaries will not owe any taxes on the life insurance pay out.
Please keep in mind that the estate tax exclusion can change, and in while the exclusion has increased in the last few years, in 2026, the estate tax exclusion is set to revert back to roughly $6 million without congressional intervention. In addition, the tax rate for estate taxes may also change, as it recently increased from 35% to 40%.
Some states also charge their own inheritance and estate taxes. In Oregon, for example, the estate tax exclusion is only $1 million dollars, and any assets worth more than this amount will be taxed at 10 to 16%.
If you need more information about life insurance, or if you would like to learn more about shielding your life insurance policy and estate from estate taxes, please give us a call at 855-247-9555 and we'll be happy to help you out.
You can also request a free online quote below to instantly compare rates from dozens of highly-rated insurers.
Managing Partner and Co-founder
Cliff is a licensed life insurance agent and one of the owners of JRC Insurance Group. He has helped thousands of families of businesses with their life insurance needs since 2012 and specializes with applicants who are less than perfect health. In his spare time he enjoys spending time with family, traveling, and the great outdoors.