Insurance and taxes are both complicated and boring. Put them together and they’re even more complicated and boring.
But, they are important. And you want to understand the rules surrounding them as much as possible. Below, we answer (in plain, simple English) a common question about taxes and life insurance… Are life insurance proceeds taxable?
So let’s just dig in and make this topic as painless as possible.
Are Life Insurance Proceeds Taxable?
The short answer to the question is that, usually, life insurance proceeds are NOT taxable. However, that’s not always the case.
When Life Insurance Proceeds Are Not Taxable
Life insurance payouts are not taxable if we are talking about income tax. This is the case when the proceeds are paid out in a one-time, lump sum payment.
However, if the life insurance payout in installments, then part of that money is taxable. When proceeds are paid out via installments, you’ll generally earn interest on the part that has not been paid out yet.
In this case you’ll pay taxes on any interest that is earned on the installment payments. However, it’s only on the interest. Not on the original payout amount.
Estate Taxes
However, the situation on whether life insurance payouts are generally taxable or not is different when it comes to estate taxes.
When it comes to estate taxes, your estate executor will need to file IRS Form 712 as part of your estate tax return. This form will report how much the life insurance policy was worth when you died.
If your estate gets passed on to your spouse, then there most likely will be no taxes involved. This is because spouses typically do not owe estate taxes on their spouse’s estate.
However, if the estate beneficiary is someone other than your spouse (such as children or parents), that’s not the case. In this situation, the life insurance payout gets added to the overall value of your estate.
If your estate is less than the federal or state exemptions, then the beneficiaries will not have to pay taxes. Currently the Federal exemption is $11.7 million. Some states also have estate taxes. Exemption levels vary from state to state.
If these exemptions are an issue, you can try to avoid them by setting up an Irrevocable Life Insurance Trust (ILIT).
Bottom Line
The two situations above are the main ones most people who have (or are the beneficiary of) a life insurance policy face regarding taxes. There are some other, less common situations. But, at the risk of making this even more complex and/or boring, we’re going to skip them here.
So, bottom line, tax insurance proceeds typically are not subject to taxes. But, for those who have large estates, the estate tax may come into play.
