There are a few things to know about taxation and inherited money from a loved one’s death. First, the inheritance itself is not taxed as income.

However, if the death benefit paid to your heirs exceeds state and federal exemptions, it may be taxed as part of your estate. Additionally, if you elect to dump your policy via a settlement or by surrender to the insurer, you may face income and capital gains taxes.


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Additionally, if a beneficiary elects to receive the death benefit in installments rather than a lump sum, the interest paid by the insurer will likely be taxable.


What about Estate and Inheritance Taxes?

Estate taxes can be a considerable burden on your loved ones after you die. To make sure they don’t have to pay more than they have to, it’s important to understand how life insurance policy payouts are taxed.

IRS Form 712 is used to calculate the value of life insurance policies for tax purposes. If your spouse is the beneficiary of your policy, the payout is not taxed and will be passed on to them tax-free. However, if your beneficiaries are anyone else, they will be taxed on the payout according to the value stated on Form 712.

Ordinarily, a spouse is immune to estate tax liability however other family members such as your parents or your children will find that the life insurance payouts are added to the value of your estate.

This will generally not be an issue as long as the total value of the estate is less than state and federal exemptions. If, however, the value of your estate exceeds the exemptions allowed at the time of your death, that amount is subject to estate and inheritance taxes.

Federal Estate Taxes

 Your tax liability for federal estate taxes will be predicated on a value that exceeds $11.8 million per individual and subject to a tax liability of up to 40%. The actual tax liability is predicated on the taxable amount of your estate.

State Inheritance and Estate Taxes

 Currently, there are 17 states and the District of Columbia that have an estate tax or inheritance tax in their statutes. The taxes in each state vary according to each state’s exemption which typically ranges from $1 million to $7 million.


State and Tax Type


Tax Rate

Connecticut Estate Tax


10.8% – 12%



10% – 20%

Illinois Estate Tax


0.8% – 16%


Avoid Estate Taxes by Using an Irrevocable Life Insurance Trust

If you are looking to avoid having your life insurance payout taxed as part of your estate, setting up an irrevocable life insurance trust (ILIT) is a great option. When you establish an ILIT, you transfer ownership of the policy to the trust, and cannot be the trustee.

An irrevocable life insurance trust (ILIT) can help you avoid having your life insurance payouts taxed as part of your estate. By transferring ownership of the policy to the ILIT, you give up control over it but can still choose the trust beneficiary. This arrangement may be beneficial if you want to keep your life insurance proceeds out of your estate.

Although an Irrevocable Life Insurance Trust is an effective method for making sure your policy’s death benefit does not become a taxable part of your estate, there are situations where you may still have a taxable event:

You could be forced to pay a gift tax if the cash value of your life insurance policy is higher than the gift tax exemption. For 2022, the exemption is $16,000.If you die within three years of transferring the policy to the trust, the policy will likely be included in your estate for tax purposes. This rule was implemented to prevent “deathbed” gifts to escape your tax liability.


The Transfer for Value Rule

The Transfer for Value Rule comes into play if you decide to sell your policy to a third party. This action is known as life insurance settlement and is typically done by a policyholder who can no longer afford policy premiums or decides that he or she no longer needs the insurance policy.

The transaction is between the policy owner and a third party who pays a lump sum to become the policy owner and beneficiary and takes responsibility for any outstanding premiums.

When you die, your life insurance policy’s death benefit becomes taxable to the third party in the transaction. However, they don’t have to pay income taxes on the full amount. Instead, only a portion of it is taxed – this includes any money paid to you as part of owning or acquiring the policy, as well as any premiums paid since then.

Additionally, you, as the seller of the policy, may be subject to income taxes. Taxes will likely be levied on a portion of the life insurance settlement (transaction with a third party), while capital gains tax may apply to the rest.


What if I Surrender my Policy Instead of Selling It?

Life insurance can be a great financial safety net. But what happens when you no longer need or want your policy? Surrendering your life insurance policy, or being unable to get a life insurance settlement, can have tax implications depending on the policy’s cash value. Here’s what you need to know about taxes and surrendered life insurance policies.

Generally speaking, you won’t owe any taxes on a life insurance policy as long as the cash surrender value is less than the amount you’ve paid in premiums. However, any cash value above and beyond your premiums is considered taxable income.

Term life insurance policies don’t have a cash value and as such wouldn’t be subject to any taxes upon surrendering the policy. However, you also wouldn’t receive any money back from the insurer either.


Frequently Asked Questions

How do I avoid taxes on life insurance proceeds?

If you are looking to avoid having your life insurance payout taxed as part of your estate, setting up an irrevocable life insurance trust (ILIT) is a great option.


Do you pay taxes on cash withdrawals?

If you withdraw up to the amount of the total premiums paid into the policy, it is not taxable as it is considered a return of premiums. If, however, you then withdraw any gains on the policy (e.g., dividends), then these amounts could be taxed as ordinary income.


Do you have to pay taxes on money received as a beneficiary?

Generally, the beneficiary on a life insurance policy is not taxed on the death benefit unless they elect to leave the benefit with the insurer in order to earn interest. If you the beneficiary elects to receive the payout in installments, the interest earned is taxable.


Is a lump sum death benefit taxable?

A life insurance death benefit that is received in a lump sum is typically not taxable to the beneficiary.

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