Do you need to pay taxes on a life insurance payout? Usually not, but there are a few exceptions

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  • Proceeds to a beneficiary from a life insurance policy typical aren’t taxable.
  • Exceptions apply when there is interest and when premiums are written off as expenses.
  • It is best to talk to an accountant if you think you have taxable life insurance proceeds.
  • See Insider’s picks for the best life insurance companies.

The most recognized benefit of life insurance is the death benefit. When a life insurance policyholder dies, their beneficiaries receive a death benefit, funds so they can continue without worrying about the loss of income.

One unsung advantage of life insurance is the tax-deferred benefits; you do not have to pay taxes on proceeds from a life insurance payout. However, there are a few exceptions to this rule.

Life insurance payouts aren’t taxable with a few exceptions

According to the IRS, “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. However, any interest you receive is taxable and you should report it as interest received.”

Cash value life insurance policies

Mark Williams, CEO of Brokers International, told Insider that one instance where life insurance beneficiaries may have to pay taxes is if the death benefit includes a pay out of cash value.

Cash value is a feature unique to permanent life insurance policies. All permanent life insurance policies have death benefits as well as a cash value that grows on a tax-deferred basis. The big difference between the types of permanent life insurance policies is how they manage the cash value —  in the insurance company’s portfolio, stock market, or annuities.

Williams warned that because the money inside the policy (cash value) has been growing on a tax-deferred basis, you will pay taxes on the cash value upon surrendering the policy or if it’s paid out to a beneficiary.

Writing off premiums as a business expense 

Williams said writing off life insurance premiums on your taxes can trigger a taxable event for the beneficiary. He gave the following example:

Two business partners have 50/50 ownership in a business venture with the right to purchase the other’s ownership interest in the event of death. They purchased a business life insurance policy and write off the premiums as a business expense. Upon the death of one partner, the surviving partner uses the life insurance proceeds to purchase the deceased partner’s ownership interest. This will trigger a taxable event.

It’s important to talk to your accountant to make sure you don’t have a taxable event.

The 2 types of life insurance

Life insurance is a contract between you and the life insurance company where you pay premiums (monthly or annually) for a payout that your living relatives will receive, known as the death benefit. Should you die, the insurance company pays the death benefit to your chosen beneficiary.

There are two types of life insurance: permanent life and term life. The difference between

term life insurance
and permanent life insurance is similar to the difference between renting an apartment (term life) and owning a home (permanent life). 

When you rent, you have a lease for a certain term. When that lease is over, you can renew — but most likely with a rent increase. Term life insurance lasts for a specified period. When it’s up you can reapply for coverage, but the premiums most likely will go up as you age.

Permanent life insurance never expires, has a death benefit for your beneficiaries, and a cash value that you can use during your lifetime. It’s like owning a home, where you gain equity that can be used as collateral — and your home can be left to your heirs leaving a legacy.

Although the term “whole life insurance” is often used synonymously with permanent life insurance, whole life, universal life, and variable life are actually types of permanent life insurance. Other permanent life insurance policies are a variation of these three products.

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