Is life insurance taxable?

Read on for a few important points about the taxable nature of your life insurance policy.

Death benefits usually aren't taxed.

In most cases, beneficiaries don't pay income taxes on the base life insurance death benefit they receive. However, there can be situations that do create a taxable event.

The payout is part of a taxable estate.

If the life insurance policy owner's estate exceeds certain thresholds, there could be estate tax consequences at federal, state or both levels.

Also look out for situations where an owner's estate is below the estate tax exemption level, but a large death benefit paid to the estate could push it into the taxable territory.

Your state imposes inheritance taxes.

Inheritance tax is different from estate tax. An inheritance tax is a tax on the assets received by a beneficiary, whereas the estate tax is based on the total value of a deceased person's estate before distribution.

Most of the time, a beneficiary does not have to pay inheritance tax on life insurance proceeds, but there are few states that do impose this tax under certain situations. This could also apply when the death benefit proceeds are paid to the deceased's estate instead of a named individual.

This is one reason it's important to review the details of your policy as it relates to your overall financial plan. Because tax laws are constantly changing, understanding how that can impact your legacy plan is important.

The IRS decides it's a taxable gift.

Life insurance is like a triangle with three parties involved: the owner, the insured and the beneficiary. When a different person plays each role, the life insurance world calls this the unholy trinity. If this is the case, the IRS may determine that the payout is a financial gift from the policy owner to the beneficiary.

To avoid tax trouble, consult a trusted tax professional when planning your estate or dealing with an inheritance. Pay special attention to whoever you choose to fill each role within the policy. A safe play can be to have the same person act as either the owner and the insured or have the owner and the beneficiary be the same person.

The beneficiary receives the benefit in installments.

We've established that lump sum death benefit payouts are usually tax-free. But some life insurance companies offer to pay the death benefit in installments. These payments are also known as income annuities.

If you opt for installment payments, the benefits balance earns interest. Because that interest could be subject to tax, you may have to report it as income when you file your taxes.

Tax implications of accessing the cash value.

Policyholders can build up a cash value as they pay the premiums on their permanent life insurance policies. Taxes on this cash value are generally deferred — but only as long as the policy stays active.

You may create tax liability by taking cash value through withdrawal or surrender. This occurs with any amount above the cost basis, or how much you paid in policy premiums.

For example, if you cancel the policy and the cash value is higher than your cost basis, then you may have to pay taxes on those net proceeds.

A loan could also be taxable in certain situations, such as if the policy is considered a modified endowment contract.

Are life insurance premiums tax deductible?

Life insurance premiums are not tax deductible. While there are some exceptions, these usually only apply to businesses. For example, a business might be able to deduct the premiums it pays on behalf of its employees up to certain limitations.

Life insurance tax strategies

There are other ways to leverage life insurance's contractual nature.

If you're a high-net-worth individual, you can use life insurance as a tool to help with estate taxes. This happens through something called an irrevocable life insurance trust, or ILIT. By naming an ILIT as the owner of the life insurance policy, the death benefit is not counted as an asset of your estate.

Policyholders may also receive a tax deduction by naming a charity as owner and beneficiary of a policy. Whether premiums continue or they are no longer required to keep the life insurance benefit active, the donor may be eligible for tax benefits.

Keep in mind, these strategies have complex rules and eligibility may vary.

To ensure you're maximizing the benefits of your life insurance policy, have a professional review your estate plan. And for more helpful tax tips and resources, visit the USAA Tax Center.