Is life insurance taxable?

• Proceeds from a life insurance policy to a beneficiary typically aren't taxable.
• Exceptions apply when there is cash value, and when premiums are written off as expenses.
• It's best to talk to an accountant if you think you have taxable life insurance proceeds.
• See Insider's guide to the best life insurance companies.

The most recognized benefit of life insurance is the death benefit. When a policyholder dies, the beneficiary receives a cash payout.

Generally, you do not have to pay taxes on proceeds from a life insurance payout. However, there are a few exceptions to this rule.

Is life insurance taxable?

According to the IRS, "life insurance proceeds you receive as a beneficiary due to the death of the insured person aren't included 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."

Term life insurance doesn't have cash value, and the death benefit comes as a lump-sum payment. However, if you have cash value permanent life insurance policies, there may be tax implications.

Exceptions to the non-taxable rule on life insurance payouts

Mark Williams, CEO of Brokers International, told Insider that there are some instances where life insurance beneficiaries may have to pay taxes on the death benefit:

1. Cash value permanent life insurance policies
2. When life insurance is written off as a business expense

Cash value permanent life insurance policies

Cash value is a feature unique to permanent life insurance policies. All permanent life insurance policies have death benefits as well as a cash value that grows on a tax-deferred basis. The big difference between the types of permanent life insurance policies is how they manage the cash value —  in the insurance company's portfolio, stock market, or annuities.

Williams warned that because the money inside the permanent life insurance policy (cash value) has been growing on a tax-deferred basis, you will pay taxes on the cash value upon surrendering the policy or if it's paid out to a beneficiary. The amount of the death benefit itself is not taxable, but the cash value and its interest will be.

If you are the beneficiary of a permanent life insurance policy, the insurer will give you options on how you can receive your death benefit: as a lump-sum payment or incrementally. Incremental payments will trigger a taxable event.

High net-worth wealth individuals typically have permanent life policies to handle estate and inheritance tax concerns. Williams said that because cash value grows tax-deferred, some people overfund their permanent life insurance. This will trigger a taxable event.

It's important to talk to your accountant if you are the beneficiary of a permanent life insurance policy to understand the tax implications.

Writing off premiums as a business expense 

Williams said writing off life insurance premiums on your taxes as a business expense can trigger a taxable event for the beneficiary. This can happen if you have an employer group life insurance policy or as a business partner. He gave the following example:

Two business partners have 50/50 ownership in a business venture with the right to purchase the other's ownership interest in the event of death. They purchased a business life insurance policy and write off the premiums as a business expense. Upon the death of one partner, the surviving partner uses the life insurance proceeds to purchase the deceased partner's ownership interest. This will trigger a taxable event.

If your employer provides you with group life insurance and writes off premiums paid as a business expense, if you die while employed, your beneficiary may have to pay taxes on the death benefit, particularly if you increased your benefit amount.

If you are the beneficiary of a group life insurance policy or a business partner, it's important to talk to your accountant to understand the tax implications.