Is Life Insurance Taxable? Generally, No.

Death is inevitable, which makes life insurance all that much more important. As you consider the needs of your beneficiaries, several questions may arise. For example: "Are life insurance proceeds taxable?" You may also wonder how a life insurance payout works. The answers require more than a one syllable answer, so here, we break it down for you.

More often than not, a life insurance claim is not taxable. Here's when a beneficiary can expect to not pay tax on a life insurance payout:

When it doesn't exceed estate tax limits

Life insurance is not taxable by the federal government unless it exceeds the federal estate tax limit. As of 2022, the limit is set at $12.06 million. And currently, only 13 states impose a death tax, although the amount is too high to impact most people. As long as the decedent's estate is worth less than $12.06 million (or the state limit), most beneficiaries will never have to pay a life insurance tax.

When the insurance company retains the cash value

There are two primary types of life insurance: Term and whole life. As the name implies, term life insurance lasts for a specific number of years. The policyholder pays their premium and coverage lasts until the "term" on the policy expires.

Whole life policies are a type of cash value life insurance. That means a policy may build cash value that can be used to pay premiums or as collateral for a life insurance loan.

Typically, when the policyholder dies, the insurance company pays beneficiaries the death amount, but keeps any cash value that has built over the years. Since the beneficiaries rarely get the cash value, there are no taxes to be paid.

Even if a beneficiary does receive some of the cash value (as a few policy types allow), the amount received would have to exceed the total amount the policyholder paid into the policy over the years. It is highly doubtful that would happen.

When the policyholder makes a partial withdrawal

One reason some people like whole life policies is because of the cash value we mentioned. If the policyholder decides to withdraw part of the cash value while they're alive, it's not taxable. However, if they don't repay the money before they die, the balance will be subtracted from their death benefit and their beneficiaries will receive less.

When a whole life policy is surrendered

Say a policyholder decides they have enough money in the bank to take care of their beneficiaries after they die and cancels (or surrenders) their policy. Most insurance companies will return cash that has accrued in the account, minus surrender fees (which can be costly). As long as the payout is smaller than the total amount the policyholder has paid into the account, the lump sum of cash is not taxable.

When annual dividends are less than annual premium payments

Some whole life policies pay annual cash dividends. Unless the dividend is more than the policyholder paid in premiums that year, it is not taxable.

When death benefits are accelerated

When a policyholder is diagnosed with a terminal illness and given a life expectancy of under two years, they have the option of receiving some or all of their death benefit prior to dying. It makes sense for someone who needs the funds to pay for medical care. Essentially, they become their own beneficiary and are not required to pay taxes on the proceeds.

When life insurance is taxable

Is life insurance taxable? Yes, under certain (somewhat rare) circumstances. For example:

When the estate exceeds federal and/or state thresholds

If a decedent's estate is worth more than the federal or state estate threshold, taxes will be due.

When a "skip person" is named as beneficiary

Do you pay taxes on life insurance? It is possible, if it's paid to a "skip person." A skip person is a beneficiary who is two or more generations younger than the deceased. For example, a grandchild or great-grandchild is considered a skip person. When a spouse or child is named as a beneficiary, life insurance proceeds are not considered part of the estate and are not taxed. However, if the beneficiary is a skip person, the value of the death benefit is considered part of the estate. If the total estate value exceeds federal and/or state estate thresholds, taxes will be assessed.

When three people are involved

There are normally only two parties involved in a life insurance policy -- the policyholder (who is typically the insured party) and the primary beneficiary. In that case, there's no tax owed. Now, let's say a parent purchases a life insurance policy for their grown child and names their child's spouse as the beneficiary. While it's a lovely thing to do, the spouse will owe taxes on the death benefit because three people were involved. In this case, the answer to whether insurance proceeds are taxable is "yes."

When a policy is sold

There are plenty of people who either want to broker the purchase or to buy an existing whole life policy. For one moment, let's stop asking "is a life insurance payout taxable," and focus on the dangers of selling a policy. Here's the downside of selling a life insurance policy:

• The broker selling it will take a cut, money that you paid into the policy.
• The party buying it will likely want to pay a bargain basement price (they're looking for desperate sellers).
• If, somehow, the amount received for the policy is more than the total of the premiums paid into it over the years, the difference will be taxed. For example, if a policyholder pays $15,000 into a policy before selling it, but manages to get an offer for $16,000, the extra $1,000 will be taxed.

In a nutshell: Is life insurance taxed? If it's sold for more than it cost, it will be taxed.

When there's a profit

Since whole life insurance can cost five to 15 times as much as term life, it's not uncommon for a person to surrender their whole life policy, collect the cash that has accrued, and use those funds to purchase a term life insurance policy.

Do you have to pay taxes on life insurance that's been surrendered? Yes, if the cash received is more than the premiums and fees paid into the policy. While it rarely happens, it's good to know that it is a possibility.

Note: Never surrender or sell a policy without first having another life insurance policy in place. There should be no gaps in coverage, even if it means borrowing from savings and paying savings back once the old policy has been sold or surrendered.

Are life insurance premiums tax deductible?

No, life insurance premiums are not tax deductible. The IRS views premiums as a personal expense and therefore, non-deductible.

How can I avoid tax on life insurance proceeds?

Are life insurance proceeds taxable? As we've outlined, they may be. That's what makes it so important to find legal ways to avoid paying those taxes.

Transfer ownership

Let's say a person transfers ownership of their life insurance policy to a close friend or relative before they die. If they die one or two years after transferring the policy, it may still be subject to taxation (depending on how much their estate is worth). However, if the person dies three years or more after making the transfer, the death benefit will not be included in their estate and there is less chance of it being taxed.

Caveat: When a life insurance policy is transferred to a beneficiary, it is considered a gift and under current law, any policy worth more than $16,000 can be hit with a gift tax. Fortunately, gift taxes are not due until the original policyholder dies and only if the estate exceeds $12.06 million.

Create a trust

Another way to protect life insurance from taxes is to create an irrevocable life insurance trust and then place the policy in the trust. Once it's placed in the trust, the original policyholder is no longer the owner (legally, the trust is). Any death benefits will not be part of the policyholder's estate and won't be taxed.

A trust may be the best option for a policyholder uncomfortable transferring their policy to a family member or friend.

The vast majority of people will never have to worry about paying taxes on life insurance proceeds. Are life insurance proceeds taxable? Not generally, but in the event they're going to be, proper planning can eliminate the need to share a portion of death benefits with Uncle Sam.

RELATED: What is an irrevocable life insurance trust? Check out The Ascent's guide.