You Received a Life Insurance Payout. Here's How to Avoid an IRS Audit.

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If you're receiving a life insurance payout, you've already got more than you need on your plate. The last thing you want to deal with right now is an IRS audit for not paying taxes you didn't even know you owed. The good news is you probably won't have to.

For the majority of beneficiaries, life insurance proceeds are not taxable. At both the federal and state level, the death benefit isn't treated as taxable income. Even if you're borrowing against your life insurance, you wouldn't owe taxes on the cash unless the policy is canceled or lapses before you repay it.

However, as with most things in life, there are exceptions to the rule. For example, while the cash paid out from the policy itself may be tax-free in most cases, interest earned when you invest it or stash it in a high-yield savings account isn't. The IRS might also take a cut in certain other situations as well. So, before you use your life insurance proceeds, it's worth double-checking that you really don't owe any taxes on it.

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When is life insurance taxable?

In many situations, life insurance payouts are tax-free. But there are some important exceptions that you need to know if you've received or expect to receive life insurance benefits. Here are some of the most common exceptions when you would need to pay taxes on your life insurance proceeds:

You earned interest on your life insurance benefits, either because you opted for installment payments or because you're keeping it in an interest-bearing account. In this case, you would be taxed on the interest only, not on the principal payout.
You receive the death benefit as an annuity. An alternative to receiving the death benefit in installments is to essentially use the cash to buy an annuity. This is a form of guaranteed income payments that some people use to fund their retirement. You'll be subject to annuity taxation. That typically means owing taxes on the interest that the annuity earns, but not the principal death benefit used to pay for it.
You received the death benefit early. Some policies allow for early access to benefits if the insured person is diagnosed with a terminal illness or meets other qualifying conditions. You may be taxed on the payout in this scenario.
Your cash value is worth more than the premiums you paid. If you have whole life insurance, your policy may be building cash value. For now, it's tax-deferred. But if that value exceeds the total amount you paid in premiums when you withdraw, you'd owe taxes on the profit.
The policy was sold or surrendered. If you no longer need life insurance, you may have the option to sell it to someone else or surrender it back to the company. This usually isn't an option for term life insurance, but it may be for other types. In both cases, you'd receive a cash payout for the policy. If that payout is higher than what you paid in premiums, you'll be taxed on the excess.
The life insurance was part of a large estate. If the death benefit is paid to the policyowner's estate or is otherwise included as part of their taxable estate, it might be subject to estate taxes. This will happen if the total value of the estate exceeds federal or state thresholds. As of 2025, the federal threshold is $13.99 million, though, so most people won't have to worry about this.
The life insurance was an employer-paid group plan. If you received a payout worth more than $50,000 from an employer-paid life insurance policy, the death benefit might be taxable.

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Aside from the situations above, there might be other exceptions that make all or some of your life insurance proceeds taxable depending on who owns the policy, who the beneficiary is and how it's paid.

If your situation is anything other than a standard lump-sum death benefit received after the owner of the life insurance policy has passed, it's worth double-checking to make sure you understand the tax laws surrounding the payment.

Tax laws are complicated

While the short answer is no, life insurance benefits are generally not taxable, the above shows that there are a lot of caveats and exceptions to that rule. When you factor in state-level variations in policy and the uniqueness of your individual circumstances, it can get even more complicated.

So, if you expect to receive a payout from life insurance, whether it's a death benefit or another form of withdrawal from your policy, it's worth consulting a financial adviser or tax expert to get custom advice tailored to your situation.

Rachael Green is a personal finance eCommerce writer specializing in insurance, travel, and credit cards. Before joining Kiplinger in 2025, she wrote blogs and whitepapers for financial advisors and reported on everything from the latest business news and investing trends to the best shopping deals. Her bylines have appeared in Benzinga, CBS News, Travel + Leisure, Bustle, and numerous other publications. A former digital nomad, Rachael lived in Lund, Vienna, and New York before settling down in Atlanta. She’s eager to share her tips for finding the best travel deals and navigating the logistics of managing money while living abroad. When she’s not researching the latest insurance trends or sharing the best credit card reward hacks, Rachael can be found traveling or working in her garden.