When Is Life Insurance Taxable? Four Scenarios to Consider 

1. Do Beneficiaries Pay Taxes on Life Insurance? 

Typically, a life insurance benefit is paid to the beneficiary in a lump sum, which is not taxable. However, the beneficiary may elect to receive the policy amount in installments. In this case, the benefit is placed into an account that can accrue interest. While the beneficiary will not pay taxes on the benefit itself, they will be responsible for paying income taxes on any interest accrued.  

For example¹:  

Steven is the beneficiary of a $500,000 death benefit that earns 10% interest for one year before being paid out. Steven will owe income taxes on the $50,000 in interest growth. 

2. Is Life Insurance Subject to Estate Taxes? 

The death benefit of a life insurance policy is typically paid directly to the beneficiaries named. In the case that the benefit is included in the estate, it is subject to potential Federal and State estate taxes if it is above the tax exemption amount: 

• The Federal exemption² is currently $12.92 million for a single person, and nearly $26 million for a married couple. 
• About a dozen states have state estate taxes³ with exemptions varying between $1 million and $9.1 million. 

If the death benefit amount is above these exemptions, any amount above the threshold would be subject to estate taxes. 

3. Policy Riders and Taxes

Policy riders are optional features that can be added to a life insurance policy to help cover life events that a standard policy does not. These riders are typically not subject to taxes but would reduce the amount that your beneficiary receives. 

WAEPA’s Chronic Illness Rider allows policyholders to collect up to 50% of their Group Term Life Insurance benefit to help cover the costs of a chronic illness. This tax-free benefit is paid directly to the policyholder over a four-year period, to be used as they see fit. 

Learn more** about WAEPA’s Chronic Illness Rider > 

4. Avoiding the Goodman Triangle 

A life insurance death benefit would be subject to taxes in the event of a taxable gift. This happens when three people serve three different roles in connection to the policy: 

• The policyholder: the person who purchased the policy and is responsible for payment of the premiums. 
• The insured: the person whose life is covered by the policy. 
• The beneficiary: the person who receives the death benefit when the insured passes away. 

Say Robert purchases a life insurance policy for his wife Barbara. They name their son Cody as the beneficiary. If Barbara passes away and Cody receives the death benefit, the IRS considers this a taxable gift from Robert to Cody, as Robert was the policyholder. This is also known as a “Goodman triangle” and in this case, the policyholder, Robert, may have to pay gift taxes for any benefit amount that exceeds Federal gift tax exemption limits⁴: 

• The annual gift exclusion is $16,000 per individual 
• The lifetime limit is $12.06 million per individual 

To avoid this scenario, Barbara could purchase and make payments on a policy herself, with Cody still named as the beneficiary. 

While life insurance is not typically taxable, these scenarios should be considered when purchasing a life insurance policy and estate planning.  

See WAEPA’s library of estate planning resources > 

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