Do I need to pay federal income tax on life insurance proceeds?


Generally, life insurance proceeds do not count as taxable income under federal law. Beneficiaries of these proceeds do not even have to report them to the IRS. For a beneficiary to benefit from tax-free proceeds, there has to be proper designation by the policyholder.

However, there are certain circumstances where these proceeds may become subject to tax.

Do you have to pay income tax on life insurance benefits?

The safest answer is “it depends.”

Death benefits arising from life insurance policies are tax-free. However, you may be required to pay income tax if you earned interest on those benefits. Or, if you have other balances that go over the amount specified on the policy.

When is the death benefit income tax free and when is it taxable?

It is tax free if it did not earn interest or if it did not grow to more than what was invested in the policy.

There are several instances where it becomes taxable:

  • When interest is accrued on the insurance policy. Any interest earned should be reported and be subject to tax. For example, the beneficiary receives a payout of $31,500. Of this amount, $30,000 is the death benefit and $1,500 is interest earned. The $1,500 should be reported and be subject to tax.

    The same holds true even on proceeds that are given in installments. If these earned interest they would have to be reported and be subject to tax. There is, however, an exception: if the proceeds paid out are in relation to the death of a spouse prior to 23 October 1986, exclusions are allowed up to $1,000 each year applicable to the interest earned which became part of the installments.

  • When the policy gets transferred to another individual or party in exchange for cash. The amount paid to the original beneficiary may be considered as taxable income. For instance, you sold a policy to your friend for $2,000. That amount you receive will constitute as taxable income and must be reported.

  • When policy is cashed in. This is applicable to policies that also serve as investment instruments. If the amount taken out is greater than the amount invested in the policy, the difference may be subject to tax. For example, you invested $100,000 on a policy that invests part of the premium on certain instruments. When you decided to cash in on that policy you received $110,000. The $10,000 becomes taxable income.

Bear in mind that the above information only relate to federal tax laws. States may have their own laws. It would be wise to check these local laws as well.

How do you report life insurance income on your federal tax return?

The insurance carrier should send out Form No. 1099-R. This is a statement that shows the dollar amounts paid to the beneficiary and which part of that amount is subject to tax.

The total amount will then be reported by the beneficiary on IRS Form 1040 in line number 16a, under pensions and annuities. The amount to be taxed should be reported in line number 16b. For those who use Form no. 1040A, the amounts are reported in line nos. 12a and 12b, respectively.

Are life insurance premiums deductible when used to pay estate taxes?

Life insurance premiums are not deductible when declared as a personal expense on an individual's tax return. However, certain exceptions apply to those who own a business. Companies who purchase life insurance policies and name another individual as beneficiary may claim deductions on the premiums when these are declared as business-related expenses.

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