You’ve taken care of your family financially by investing in life insurance in case something happens to you. But how much of that policy’s payout will they actually receive — and is your life insurance policy’s payout taxable?  

In this article, we’ll answer some common questions related to life insurance and taxes.

Are Life Insurance Payouts Taxable?

The short answer is usually not. For most situations, the money that your beneficiaries receive from your life insurance policy does not have to be claimed as gross income, so it does not have to be reported to the IRS. However, there are some exceptions:

1. If you don’t name a beneficiary. In cases where no beneficiary is named, the insurance automatically goes to the estate, which may be taxable. The value of the estate must reach taxable thresholds to require tax payments. The federal threshold is $11.7 million, but state thresholds vary by location.

2. If your state collects inheritance taxes. There are currently six states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) that tax inherited payout, property, or additional assets. The rate of the tax varies by state and can be as little as 1%, or as much as 20% of the payout. Each state that charges inheritance tax has its own set of rules and exemptions. For example, most states will exempt your spouse and sometimes your children if you were to die. Inheritance taxes are generally higher when your beneficiary is someone who is not a family member.

3. If your beneficiary skips a generation. Generation-skipping taxes may apply if your beneficiary is either a relative that is more than one generation younger than you — such as a grandchild — or an unrelated person who is more than 37.5 years younger than you. However, generation-skipping taxes only apply if the amount reaches the same amounts as estate tax thresholds.

4. If a third person is involved in the policy. If the policyholder, insured, and beneficiary are all different, the beneficiary may be taxed. As an example, if your parent (the policyholder) took a policy out on you (insured) when you were young, then later named your spouse as your beneficiary, your spouse might have to pay taxes on the payout.

Is Permanent Life Insurance Taxable?

Permanent life insurance, such as whole life and universal life, provides coverage that doesn’t run out, as well as a cash-building aspect that is tax-deferred. There are a few instances where you may have to pay taxes on your permanent policy:

1. If you withdraw more money than you’ve paid in premiums. When you withdraw money from permanent life insurance, you are taking that money out with no plans to repay it. If you choose to withdraw, the amount will be deducted from your life insurance payout, and you may owe taxes if the amount you withdraw is larger than the amount you’ve paid in premiums.

2. If you sell your life insurance policy. You can work with a broker to sell your permanent policy for cash. The broker usually takes a portion of the payout. If you still make a profit on the sale of the policy that is more than what you’ve paid into your policy, you may have to pay taxes.

3. If you cancel your policy. If you decide to surrender your policy, not only will you lose the life insurance death benefit, you will often have to pay some extra fees. If the cash value you receive is higher than what you’ve paid in policy premiums, you will have to pay taxes on that interest.

Before you choose to take any of these steps, it’s best to talk with your insurance provider. There are generally many options available to help you get cash from your policy or reduce your premiums.

Is Term Life Insurance Taxable?

Insurance is paid with post-taxed dollars, therefore the death benefit is not taxable. However, if  premiums were paid with pre-taxed dollars, then the death benefit would be taxable.

Is Group Term Life Insurance Taxable?

If you have a group life insurance policy through the military or another job, the payout is generally not taxable, although the same exclusions discussed earlier may apply.

Contact AAFMAA to Learn More About Life Insurance

AAFMAA specializes in helping ensure the financial security and independence of servicemembers and their families. To learn more and to discuss your family’s specific life insurance needs, contact the Life Insurance team at 866-716-4579.