Are life insurance payouts taxable?

by | May 2, 2025 | Income Reporting, Individual Taxes

Here’s what HIVE AI had to say about “Are life insurance payouts taxable?”:

Generally, life insurance proceeds paid to a beneficiary due to the death of the insured person are not taxable income and don’t need to be reported on your tax return. However, there are specific situations where portions of life insurance payouts may be taxable.

Tax-Free Life Insurance Proceeds

The general rule is that death benefits from life insurance policies are excluded from gross income:

Generally, 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. IRS.gov FAQ

The proceeds from a decedent’s life insurance policy paid by reason of the decedent’s death are generally excluded from income. The exclusion applies to any beneficiary, whether a family member or other individual, a corporation, or a partnership. IRS – Publication 559: Survivors, Executors and Administrators

Section 101(a)(1) provides that gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured. Rev. Rul. 2008-42

Any amounts received under a life insurance contract that were paid because of the death of the insured are excludable from the gross income of the recipient; that is, they are not taxable. Sec. 101(a)(1). Dawson U.S. Tax Court Opinions: Bruce A. & Carol Anfinson Brown

This tax-free treatment applies to all types of life insurance policies, including:

Life insurance proceeds paid to you because of the death of the insured person aren’t taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract issued on or before December 31, 1984. IRS – Publication 554: Tax Guide for Seniors

Situations Where Life Insurance Proceeds May Be Taxable

While the death benefit is generally tax-free, there are several situations where you may owe taxes on life insurance proceeds:

1. Interest Income

However, interest income received as a result of life insurance proceeds may be taxable. IRS – Publication 554: Tax Guide for Seniors

The amounts held by an insurer with respect to any beneficiary shall be prorated (in accordance with such regulations as may be prescribed by the Secretary) over the period or periods with respect to which such payments are to be made. There shall be excluded from the gross income of such beneficiary in the taxable year received any amount determined by such proration. Gross income includes, to the extent not excluded by the preceding sentence, amounts received under agreements to which this subsection applies. IRC § 101(d)

2. Transferred Policies

If the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts. There are some exceptions to this rule. IRS.gov FAQ

3. Installment Payments

If you receive life insurance proceeds in installments rather than a lump sum, a portion of each payment may be taxable:

If death benefits are paid to you in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person’s death. IRS – Publication 554: Tax Guide for Seniors

4. Employer-Owned Life Insurance

Section 101(j)(1) provides that death benefits from employer-owned life insurance contracts shall be taxable, in excess of premiums and other amounts paid, unless the employer-owned life insurance contract meets one of the exceptions provided under § 101(j)(2). Section 101(j)(2)(A) provides that § 101(j)(1) shall not apply to any amount received by reason of the death of an insured who, with respect to an applicable policyholder (i) was an employee at any time during the 12-month period before the insured’s death, or (ii) is, at the time the contract is issued a director, a highly compensated employee within the meaning of § 414(q) (without regard to paragraph (1)(B)(ii) thereof), or a highly compensated individual within the meaning of § 105(h)(5), except that “35 percent” shall be substituted for “25 percent” in subparagraph (C) thereof. Rev. Rul. 2008-42

5. Policy Loans and Surrenders

If you surrender a policy for cash or if policy loans are repaid using the cash value, the amount that exceeds your investment in the contract (generally the premiums paid) is taxable:

The tax treatment of a distribution from a life insurance policy is governed by section 72. Thus, an amount received in connection with a life insurance contract which is not received as an annuity generally constitutes gross income to the extent that the amount received exceeds the investment in the insurance contract. Sec. 72(e)(1)(A), (5)(A), (C); Feder v. Commissioner, T.C. Memo. 2012-10, 2012 WL 75114, at *4. Dawson U.S. Tax Court Opinions: Samuel & Lilian Brach

Federal laws define most life insurance distributions as a taxable event once the cost of insurance has been recovered. When a policy lapses to Extended Term, cash value is released from the policy to repay the loans. To the extent that loans paid off exceed the cost of the insurance, a taxable event takes place. If a policy has a gain, it’s considered taxable as ordinary income and we must report it in the year the policy terminates for any reason, other than the death of the insured. Dawson U.S. Tax Court Opinions: Jeffrey J. Furnish

Special Situations

Accelerated Death Benefits

Accelerated death benefits received on the life of an insured individual if certain requirements are met. Accelerated death benefits are amounts received under a life insurance contract before the death of the insured. These benefits also include amounts received on the sale or assignment of the contract to a viatical settlement provider. This exclusion applies only if the insured was a terminally ill individual or a chronically ill individual. IRS – Publication 559: Survivors, Executors and Administrators

Viatical Settlements

A viatical settlement, a subset of life settlement transactions, may involve the sale of a life insurance contract, but may not be taxed as a sale. Under a viatical settlement, a policyholder may sell or assign a life insurance contract after the insured has become terminally ill or chronically ill. If any portion of the death benefit under a life insurance contract on the life of an insured who is terminally ill or chronically ill (within the meaning of § 101(g)) is sold (through the sale of the life insurance contract) or assigned in a viatical settlement to a viatical settlement provider, the amount paid for the sale or assignment of that portion is treated as an amount paid under the life insurance contract by reason of the death of the insured, rather than gain from the sale or assignment. See §§ 101(a) and (g). Amounts received under a life insurance contract paid by reason of the death of the insured are excluded from federal income tax. See § 101(a)(1). Notice 2018–41

Inside Buildup

The growth of cash value within a life insurance policy (known as “inside buildup”) is generally not taxed while the policy remains in force:

Life insurance and annuities enjoy favorable tax treatment. Under section 72, earnings that accrue to cash value and annuity policies—often referred to as the “inside buildup”—are not currently taxable to the policyholder (and in general are not taxable to the insurance company). The cash value of the policy thus grows more rapidly than the value of a taxable investment portfolio. Dawson U.S. Tax Court Opinions: Christopher S. Pascucci & Silvana B. Pascucci

The undistributed investment income (“inside buildup”) earned on premiums credited under a contract that satisfies a statutory definition of life insurance is not subject to current taxation to the owner of the contract. Dawson U.S. Tax Court Opinions: Bruce A. & Carol Anfinson Brown

Reporting Requirements

Generally, you report the taxable amount based on the type of income document you receive, such as a Form 1099-INT or Form 1099-R. For additional information, see Publication 525, Taxable and Nontaxable Income and Are the life insurance proceeds I received taxable? IRS.gov FAQ

Sections 6041(a) and (d) of the Code require all persons engaged in a trade or business, and making payment in the course of such trade or business to another person of rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income of $600 or more in a taxable year to make an information return to the Internal Revenue Service (Service), and furnish an information statement to the payee. Section 1.6041-1(c) states that income is fixed “when it is to be paid in amounts definitely predetermined,” and is determinable “whenever there is a basis of calculation by which the amount to be ascertained.” Section 1.6041-1(f)(1) provides that the amount which must be reported under Section 6041(a) and (d) is only that which is includible in the gross income of the payee. PLR-110359-24

Conclusion

In summary, life insurance death benefits paid to a beneficiary are generally not taxable income. However, you may owe taxes on:

  • Interest earned on proceeds held by the insurance company
  • Proceeds that exceed the purchase price of a transferred policy
  • The portion of installment payments that represents interest
  • Employer-owned life insurance that doesn’t meet certain requirements
  • Distributions or surrenders from a policy during the insured’s lifetime that exceed your cost basis

If you’re receiving life insurance proceeds, it’s important to understand which portions may be taxable and which are tax-free. For complex situations, consulting with a tax professional is advisable.

Sources:

Try Your AI Tax Assistant for Free!

Ready to transform your practice with agentic AI in tax? See firsthand how our cutting-edge AI tax tools can revolutionize your approach to tax research and planning.

Create Your Free Account