Do you need to pay taxes on life insurance? Here's what you should know.

If you are the beneficiary of a life insurance policy, the payout, commonly referred to as a death benefit, is usually tax-free. However, there are certain exceptions to this rule.

If you receive proceeds from a life insurance policy, it's important to understand your tax liability.

Compare and find the right life insurance policy

When withdrawing money from the cash value

Both whole life and universal life insurance policies accumulate interest, known as cash value, and policyholders can borrow against or withdraw a portion of the balance. However, if the withdrawal or loan exceeds the total premiums paid, the excess may be subject to taxation.

MassMutual offers whole and universal life insurance up to age 60 or 90, depending on the policy. In 2023, it was one of JD Power's highest-ranking insurers for customer satisfaction and it received fewer complaints than expected for a company its size, according to the National Association of Insurance Commissioners.

When surrendering a policy

When you cancel a whole or universal life insurance policy, you typically receive the cash surrender value, which is the policy's cash value minus any fees. However, you will be taxed on any cash value that has accrued as income.

Pacific Life's cash value enhancement rider increases the cash surrender value of your policy if you cancel it within the first 10 years. The California-based insurer offers a range of cash-value policies, including indexed universal life insurance, which earns interest by tracking an index like the S&P 500, and variable life insurance, which allows the policyholder to directly invest in securities.

When it's an employer-paid group life insurance

According to the IRS, any death benefit from an employer-paid life insurance policy beyond $50,000 is considered taxable income.

When payment is in installments

If you receive a policy payout in installments, any interest that accrues is taxable, but the principal death benefit remains untaxed.

When the beneficiary is an estate

If your estate is the beneficiary of your life insurance policy, the death benefit may be subject to estate taxes. In 2024, the federal estate tax ranges from 18% to 40%, depending on how much of the estate is over $13.61 million, the exclusion limit. For 2024, without congressional action, the limit will revert to $5 million (indexed for inflation) at the start of 2026. Additionally, twelve states and the District of Columbia impose an estate tax, with the exemption limit ranging from $1 million in Oregon to $13.61 million in Connecticut.

What to do with life insurance proceeds

The death benefit from your life insurance policy can help secure your financial future.

Pay off debt

A life insurance payout can help reduce high-interest debt, such as credit card bills, and improve your credit score. One effective strategy for managing mounting credit card bills is to transfer your balance to a card with a 0% introductory APR. The Wells Fargo Reflect® Card offers no interest for 21 months on purchases and qualifying balance transfers (with a variable APR of 18.24%, 24.74%, or 29.99% after that).

An emergency fund

It's a wise practice to maintain an emergency fund that can cover at least three to six months' worth of living expenses. This fund should be easily accessible and penalty-free to handle unexpected costs such as job loss, medical emergencies, home repairs, or other unforeseen expenses.

LendingClub's high-yield savings account offers a competitive yield, requiring only a $100 opening balance and providing a free ATM card.

The UFB Secure Savings HYSA offers a 5.25% annual percentage yield without any monthly fees or minimum balance requirements. Additionally, policyholders receive a complimentary ATM card and can transfer funds between direct deposit accounts at no cost.

Save for retirement

An IRA is a valuable tool for saving for retirement: In 2024, you can contribute a maximum of $7,000 to all your IRAs (or $8,000 if you're 50 or older). Fidelity's IRA is a top pick for beginners, offering an intuitive platform and a range of investment options with no fees or minimums.

Betterment is CNBC's top pick for robo-advisors, offering a hands-off investing experience with the option to open a traditional or Roth IRA for as little as $10. Additionally, Betterment offers a premium plan for savers investing at least $100,000, which includes unlimited access to certified financial planners.

Find an investment account that works for you

Bottom line

Receiving a life insurance payout in installments can expose you to tax liability, even though life insurance benefits are generally not taxed.

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