Life Insurance Benefits Aren’t Taxed (Usually)

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I was poking around on the internet the other day when I saw one of those morbid life insurance policy ads. You’ve probably seen them before too. They usually have someone kneeling at a grave or a kid wearing all black at a funeral. They ask you the pointed question of – “If you died today, who would take care of your family?” I suspect they’re trying to tap into your fear of the unknown, how your kids won’t be able to fend for themselves or how your husband or wife is going to be lost without your financial support.

First of all, my lovely wife is quite capable and she can take care of herself. I bet she’d miss my sparkling personality but after a while she’d probably be OK with it. 🙂

Second, our dog Tobey is the fiercest beagle in all the land. He’d do fine finding his own rawhide cow ears and kibble. Just the other day we left some food on the table and he managed to to jury-rig a Rube Goldberg-contraption just to get at it.

Life Insurance Death Benefit

OK, all kidding aside, life insurance is important but we haven’t looked at it yet. As I was about to tweet a joke about the ad’s morbidity, I wondered about whether life insurance benefits were taxed. As it turns out, life insurance death benefits are not taxed. Implicitly this made sense because auto insurance claims payouts aren’t taxed either. If you crash your car and the insurance company reimburses you, you don’t claim that payment as income on your tax return.

The same holds true for life insurance. It’s not obvious because your life doesn’t have a set dollar value like a car does. A particular repair will cost you a specific amount because you can go to a repair shop and get a quote. If it’s totaled, the pre-accident car could’ve been sold for a certain amount on the open market. You can’t really do that with your life, so we don’t really think about it in those terms.

If you receive more than the life insurance death benefit, then the excess is taxable and should be included on your return. If the benefit was $50,000 and you get $60,000, then $10,000 is taxable. If you get it paid out in regular installments, you can divide the total benefit by the number of installment payments to find out how much of each payment is not taxed. For example, if your benefit is $500,000 over 10 years, then $50,000 of annual life insurance death benefits is tax free.

Life Insurance Dividends

Here’s where things get a little tricky – life insurance dividends are only taxable if:

  • The amount you receive in cash is more than the amount of premiums you have paid,
  • You take the dividends as cash, as opposed to buy additional coverage,
  • Your policy is a modified endowment contract, which is a special kind of policy, and you take cash.

Life insurance can be a tricky subject, especially since there are so many plans and policies out there, so I recommend you talk to an expert before rely on anything this novice as written. As for tax treatment, a financial advisor or a tax expert will be able to give you the ins and outs of everything much better than me!

{ 34 comments, please add your thoughts now! }

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34 Responses to “Life Insurance Benefits Aren’t Taxed (Usually)”

  1. dave says:

    Good article, however it was a bit confusung when the article referred to “you”. As somtimes the “you” was the beneficary, and some times the “you” was the policy owner. Just to add to the confusion there are two additional parties in a life insurance policy, the insured, and the premium payor. Some times one person can act as more than one of the parties. I could be the owner and insured and my wife be the premium payor and beneficary.
    At the end of the day it is the owner who controles all aspects of the policy while the insured is alive, and the beneficary controles every thing after the insured dies

  2. Mark Peterson says:

    While in general life insurance proceeds are not taxed, they are included as part of your estate and add to the value of it. If the value goes over the tax-free allowance, then they could be taxed at the current estate tax rate, which is around 35%-40%.

    • Frugal says:

      I beg to differ as proceeds from the insurance policy go to the beneficiary and will not be added to the insured’s estate.

      This is why it is also called, ” The life insurance is not for you, it is for the family, the people you care about.”

      I am an insurance examiner and I agree that with too many plans and various policies, it can be very confusing.

      • dave says:

        Both Mark P and Frugal are mostly correct about life insurance and one’s estate. Life insurance owned by the decedant at time of death is included in the valuation of the decedants estate, for estate taxes. While the insurance death benefit it self is generaly not estate taxed, it has the impact of boosting the estate value. Think of it this way , A 1M death benefit would be the foundation and a 5M estate would sit on top of it and the effect would be that more of the 5M portion, that part above the tax free allowance would be estate taxable. If the 1M death bennefit came from a policy owned by some one else, it would not boost the other 5M one bit. For the vast majority of us who have no estate tax issues regardles of the amount of or ownership status of life insurance, the estate tax question is moot.Of course every ones estate plan and tax suituation is different and I am NOT giving tax or legal advice BTW, I am a life insurance agent of 25 years.

        • I second Dave’s comment. Life insurance can increase your taxable estate if you were the owner when you died (or transferred it 3 years prior to death). If estate taxes are a likely problem for you, it’s best to have the beneficiary be the owner or use a trust.

  3. Hopefully my son will be graduating from college in May. In thinking that the next few years are the years he is most likely to need help from me, I decided to take out an inexpensive term policy (I already have a small whole-life policy) to provide him with that support in the event something happens to me.

    I was surprised to discover that my medical history (cancer 10 years ago, but cancer free ever since), while not precluding me from getting health insurance, made it impossible to get life insurance.

    So, if you’re planning to get life insurance, you might want to get on with it while you are still healthy. Personally I’m for it. It’s not that expensive and in spite of your wife’s undoubted ability to take care of herself (and your ability to take care of yourself), all emotion aside, the unexpected death of a spouse is immediately financially difficult and helping to ease that difficulty is a nice gift you can give to each other.

    • saladdin says:

      Your group health insurance or personal health insurance didn’t care about the cancer? Big difference between the two.


    • Chris says:

      Agreed, start a policy now while you are still insurable and have a current need.

    • Israel Camacho says:

      Not all ins companies will deny you coverage. while it may cost you more.. there are some that will cover you. As an agent I have 2 clients off the top of my head that are covered… with dr records.. (not all cancers will be excepted) and at least 2 years of remission.

  4. Sheila says:

    As a working person who unexpectedly became disabled, while your wife may be capable of taking care of herself at this moment, what would happen if you died, and she became disabled at the same time or thereafter? And vice versa. SSD, if you can get on it, is barely enough to cover renting a room.

  5. pmulroy says:

    Just buy a 30 year level term policy and you won’t have to untangle all these details.

    A rule of thumb for any financial instrument:The more complicated it is, the more money they are making off of you.

    • dave says:

      Sorry, but it is highly doubtful that any application for any amount of any form of life insurance would be accepted by a company with out thorough underwriting. Included in the underwriting would be evaluating the answers to all the medical and other questions on the application, a review of doctors records, and perhaps an exam including blood and urine. Yes some companies might accept applications for small face amounts or for young, <18Y, in some cases. Also some companies issue policies of limited amounts for older persons with out medical questions,they cost more and have exclusions and other limits. Term insurance requires all the underwriting that permanent polices do

  6. saladdin says:

    The ads that want you to get life insurance on a newborn infant freak me the hell out.


    • daenyll says:

      I second that thought. Insurance should benefit the dependants not be on the dependants lives.

    • lostAnnfound says:

      We added both our kids to my policy with a $10,000 benefit each shortly after they were born. I don’t like to think about them dying before me, but if one of them did we would be able to cover funeral expenses or any medical bills that might be owed. It cost about $10.00 per year per kid to add them on to my term policy. Again, not something I want to think about, but it’s about being prepared for the worst.

      • saladdin says:

        But the odds are your kids will grow up to be healthy, divorced adults. Wouldn’t medical bills be covered by your health insurance and why not self insure for burial?


        • CK says:

          I agree with Saladdin on this one.

        • Israel Camacho says:

          it is not just about if your child dies.. if they become terminally ill.. and you had them previously covered as a child rider.. they can not be denied coverage.. up to 5X the coverage. at least though us.. there are options for people.. you should smartly plan for the future.. both the worst and best side.. its closed minded to believe that you will be the person or family that nothing happens. All families all say the same thing.. “I’ve heard of this happening.. but you never believe that it will happen to you” better to be prepared then doing the I WISH game.

      • Evan says:

        I never understood this – and it is probably the opposite of most people reading bargaineering…why ONLY $10,000?

        Are you really going back to work 40 hours the week (or 3 weeks if you have enough vacation time saved up) after your child dies?

        If Jim allows:

      • Sheila says:

        After having my son experience this, I think it’s wise. Making financial decisions after a child has died is really tough–parents want kids to have the best funeral possible (in my experience), which is expensive. Our granddaughter’s funeral was about $10,000. My son had taken out a small life insurance policy much like the one you mention.

      • Shirley says:

        We took out Globe Life insurance policies for $5,000 for each of the grandchildren when they reached one year old. This was intended to help their parents with final expenses if the child were to die. At $20 per year, it’s a small price to pay for a certain degree of peace of mind and if it’s never paid out, so much the better. 🙂

      • NateUVM says:

        I’m in the fortunate position of having a small life insurance policy on both my wife and my child through my employer, covered at no extra cost to me. Not sure how I would feel about paying for it, myself, as the benefit is for only $5,000, in each case, but I do know that I feel better having it. If either were to pre-decease me, I don’t know how much of a mood to coordinate expenses I would be in.

  7. Evan says:

    Under IRC Section 2042,
    “The value of the gross estate shall include the value of all
    property –
    (1) Receivable by the executor
    To the extent of the amount receivable by the executor as insurance under policies on the life of the decedent.
    (2) Receivable by other beneficiaries To the extent of the amount receivable by all other beneficiaries as insurance under policies on the life of the decedent with respect to which the decedent possessed at his death any of the incidents of ownership, exercisable either alone
    or in conjunction with any other person. For purposes of the preceding sentence, the term “incident of ownership” includes a
    reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent. As used in this paragraph, the term “reversionary interest”
    includes a possibility that the policy, or the proceeds of the policy, may return to the decedent or his estate, or may be subject to a power of disposition by him. The value of a
    reversionary interest at any time shall be determined (without regard to the fact of the decedent’s death) by usual methods of
    valuation, including the use of tables of mortality and actuarial principles, pursuant to regulations prescribed by the Secretary. In determining the value of a possibility that the policy or proceeds thereof may be subject to a power of disposition by the decedent, such possibility shall be valued as if it were a
    possibility that such policy or proceeds may return to the decedent or his estate.”

    This area of the life insurance can get very complicated very fast if you transfer the policy for value which would make the death benefit income taxable to the receipent.

    There are also instances when life insurance owned by a 401(k) plan where a part of the policy (mainly the CSV) would be taxable.

    I am an attorney that works in a financial planning firm – the above sections are not usually known/understood by those in the industry.

    • Frugal says:

      I believe most of the people will not be subjected to IRC section 2042.

      Also keeping it simple, the interest in your post will be taxed as it is an income upon receipt and naturally, any asset owned (receivable in any capacity) should be included in the estate as long as you own it.

      • Evan says:

        “I believe most of the people will not be subjected to IRC section 2042.”

        Why? Because they won’t meet minimum thresholds of Estate Tax ($3.5mil in 2009; unlimited thus far in 2010)?

        What about State Estate Taxes? 18 States and DC have them. In New York that amount is $1,000,000 in NJ it is $675,000

  8. zapeta says:

    So, after reading the article and comments I see this is a complicated subject. Thanks to everyone for explaining the tax implications.

    As for myself, I have life insurance…I don’t have any dependents but in any case someone would have to pay for my funeral and I wouldn’t want them to be left holding the bag.

    • Chris says:

      I assume your coverage is minimal (funeral expenses) and if more than that you have beneficiaries depending on you?

  9. mikestreb says:

    I had been told before by my company’s benefits coordinator that they won’t take out life insurance premiums pre-tax (cafeteria style), because if you use pre-tax dollars, the benefit is taxable….

    Don’t know how much truth there was to that, but I elected to pay the tax on the $10/mo as to not screw up BIG time on the benefit…

    • Anonymous says:

      Who pays the premium does help determine taxable status.

      Surprises me. Cafeteria plans favor the business. They save on taxes etc… I wonder if your coordinator really understands how they work.

      Funny story. I had printed off a “How Cafeteria Plans Work” booklet off the net this week and had it sitting on my table at home. My girlfriend walks by and says “Your work is getting a cafeteria?” I just looked at her and said “Not the food kind.”

      She’s a good one.


      • mikestreb says:

        That is great! Had my wife seen a book like that, I guarantee she would have said the same thing!!!

    • Mike – it wouldn’t surprise me if you coordinator was clueless.

      My wife’s employer (thousands of employees) recommends, on their web site, paying for disability insurance with after-tax money “because it is unlikely you will become disabled.” Those are their words, not mine.

      Yes, they’re suggesting that you save a few dollars a month in taxes now and possibly incur hundreds of thousands of taxes in the future.

      My own employer smartly avoids giving tax advice – particularly bad tax advice.

  10. I heard that death benefits are taxable if the payee doesn’t own the policy. In other words, if your adult child is the beneficiary of a life insurance policy that you pay for, she or he will have to pay income tax on it if you croak over. That may not apply to married couples, at least if you’re in a community property state; dunno, but might be wise to look into it.

    Consider life insurance for your spouse, especially if she’s a SAHM. Price out what it would cost to put your kids in day care or have a caretaker in your home, to hire someone to schlep them to practices and other extracurricular activities, to clean house and prepare meals, and to run all the errands she’s doing while you’re at work. Now multiply that times the several years it may take you to recover from widowhood and find a new wife, add the cost of burial and the cost of therapy for yourself and the kiddies, and you’ve got the amount for which she should be insured.

    • Evan says:

      “I heard that death benefits are taxable if the payee doesn’t own the policy. In other words, if your adult child is the beneficiary of a life insurance policy that you pay for, she or he will have to pay income tax on it if you croak over.”

      This is wrong – there may be gifting issues, but it depends who owns the policy (adult child vs. a for profit company).

      I completely agree with on the SAHM issue.

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