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Is life insurance taxable?

Whether or not your life insurance policy is taxable depends on the situation. /Getty Images

Life insurance is a valuable part of many people's financial plans. It helps take care of your loved ones after you die, can provide an inheritance for your heirs and it may even provide cash during your lifetime, depending on the policy type. For these reasons, life insurance could be worth it for you, whether you're young or old.

But, as with many financial products, there are tax considerations to keep in mind. In this article, we go over when life insurance is (and is not) taxable.

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Is life insurance taxable?

The short answer is: It depends. Here are the situations when you may need to consider taxes on your life insurance policy.

Payouts to beneficiaries

If your beneficiaries opt to receive the death benefit as a lump-sum payout, they won't have to pay taxes on it. If they choose to receive payments over several years (known as an annuity), they may earn interest on those payments, which the IRS considers taxable income.

"Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them," the IRS says. "However, any interest you receive is taxable and you should report it as interest received."

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Cash value

Whole life insurance policies build cash value, which you can use while you're alive. If you access this cash value and it's more than the premium payments you've made so far, the difference may be taxable. Term life insurance does not build cash value, so this situation does not apply to those policies.

Surrendering your policy

If you decide you no longer need (or want) your life insurance policy, you can surrender it to your insurance provider for cash. If the amount you receive is more than the premium payments you've made so far, the difference may be taxable.

Selling your policy

You can also sell your policy to a third party in a process known as a life settlement. It can be complicated, and it's often wiser to reduce your coverage or surrender your policy. But if you choose to go this route, the tax consequences are the same as they are for accessing cash value or surrendering. If the proceeds exceed the premium payments you've made to date, the difference may be taxable.

Estate taxes

If your estate is worth more than the estate tax exemption, the IRS counts your life insurance proceeds toward your total estate value. That means your heirs must pay estate tax on any amount over the exemption. For the tax year 2023, this exemption is $12.92 million for individuals and $25.84 million for married couples filing jointly. 

You can avoid estate tax by creating an irrevocable life insurance trust (ILIT) and using that trust to pay your policy's premiums. This keeps your policy proceeds from being counted in your estate value.

Request a free estimate now to see how much life insurance coverage you can get.

Gift tax

Typically, there are two parties in a life insurance policy: the person who buys the policy for themselves and the beneficiary (or beneficiaries). However, sometimes, someone buys a policy for another person, which adds a third party to the equation. If this is the case, the IRS classifies the death benefit as a gift, which means it may be subject to taxation.

As with estate taxes, gift tax only applies if your estate value exceeds $12.92 million for individuals or $25.84 million for married couples filing jointly.

The bottom line

To determine how taxes might affect your life insurance, consult with a tax professional. Whether or not your policy results in taxes, there are many reasons why it's still worth having. Make sure you're getting the most out of your policy by requesting offers from the best life insurance companies and comparing them with your needs and goals.

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