Are Life Insurance Benefits Taxable?

Taxes are complicated…so complicated that IRS Commissioner Douglas Shulman recently disclosed he hires somebody because he finds doing his own returns too complex. He’s not alone. The vast majority of Americans (Shulman says 80%) now rely on professional tax services and software. Just thinking about what you don’t know about our 14,000-page tax code taxes is frightening. We’re not going to clear up the mystery in 400 words, but we can shed a little light on life insurance and income tax returns.

For starters, life insurance benefits are not taxable…most of the time. We’ll get around to the possible exceptions in a minute. For now, just be happy that any benefits you receive when someone dies and names you beneficiary are not considered taxable income. That means you don’t need to report the life insurance payout on your U.S. tax return.

You do have to declare any interest you receive on life insurance policy dividends. The dividends themselves aren’t taxable but the interest paid on them is. It must be declared as income during the tax year that it is credited to your account and is available to be withdrawn (i.e. spent). If, on the other hand, the interest on your life insurance is only available for withdrawal on a specific date (typically the anniversary of the policy), you should declare it as income during that tax year.

Now for the exceptions under which life insurance benefits may be taxable:

If you acquire a life insurance policy through a transfer for valuable consideration, you can only exclude as taxable income the amount of consideration you paid. After that and moving forward, you can also deduct any premiums you pay on the policy.

If you own a business as a sole proprietor and have a key-employee life insurance policy, the payout may be excluded as income, but you can’t deduct your premiums since the company will be the beneficiary of the policy.

Death benefits received in excess of premiums paid on corporate-owned life insurance issued after August 17, 2006 may count as taxable income.

Death benefits paid to C corporations may increase the corporation’s alternative minimum tax liability.

Clear as mud, huh? Considering what’s at stake if you mess up on your tax return, the really smart money is on hiring a professional if you want to be sure whether or not your life insurance benefits are taxable.


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