When you're getting your affairs lined up, it's natural to wonder whether any portion of it won't make it to your heirs. After all, taxes take a bite out of most big payments. Does that mean the proceeds of your life insurance policy will be taxed, too?

Well, the short answer is: usually not.

But sometimes they are, and this article will help you know what to expect and give you enough background info to intelligently discuss the issue with your financial advisor.

What Doesn't Get Taxed

Spouses

If the proceeds of the policy go to your husband or wife, they will not be taxed. This is the case even if your estate is large enough to be subject to taxes.

Other Beneficiaries

If the proceeds of the policy go to someone other than a spouse, they are not taxed.

But there is one exception to this rule: if the proceeds go to your estate and then in turn to the beneficiaries, they will be taxed. That is, of course, assuming your estate is large enough (as of the 2017 tax year, the first $5.49 million is exempt from federal estate taxes).

Irrevocable Life Insurance Trust (ILIT)

An irrevocable life insurance trust is a trust that cannot be amended or revoked and can be the owner or beneficiary of life insurance policies. As long as the rules governing ILITs are followed, the payouts from the life insurance policies it owns or benefits from will not be taxable (for related reading, see Your Basic Guide to Trusts).

(Note that ILITs must be created at least three years prior to the death of the insured in order to be considered valid by the IRS.)

Cash Value

A whole life policy builds cash value over the course of its life. Any gains in the value of the policy due to this are tax exempt as long as the increase does not exceed the amount paid in premiums.

Surrender Payout

Life insurance policies typically have a surrender payout value. This allows you to cancel the policy at any time and receive a certain lump sum value immediately. If the surrender value is less than what you paid in premiums while you held the policy, the payout is not taxed.

(Taking the surrender payout is never ideal. If you need cash, consider instead taking out a loan with the cash value as the collateral. The funds you receive from the loan are not taxable, and by keeping the policy in force, it will continue to accrue cash value.)

Dividends

If the insurer you buy your policy from is a mutual life insurance company owned by its policyholders, you may occasionally be paid dividends. These are not taxable as long as the amount paid is less than what you have paid in premiums.

What Gets Taxed

State Taxes

Some states have inheritance taxes, and the exemption level is often significantly lower than the federal exemption.

State inheritance tax rates can be as high as 20%, so this could significantly affect your decision to buy life insurance. If you live in a state with a high inheritance tax rate and an exemption level that is lower than the value of your estate, life insurance might not be a good idea. Consult a financial advisor to review your options.

Proceeds Payable to the Estate

As mentioned above, if the proceeds are payable to your estate instead of directly to the beneficiaries, the estate will be taxed if the total assets, including the life insurance payout, exceed the exemption level. This was $5.49 million in 2017 for the IRS but is lower in many of the states that have inheritance taxes.

Payout Over Time

Some life insurance policies provide an option for the beneficiary to be paid over time rather than in a lump sum. If a beneficiary elects to be paid over time, interest (and only interest) that has accumulated is subject to being taxed, depending on the particular beneficiary’s tax situation.

Large Estates

If you have an estate that is likely to be taxed by the federal government due to the fact that it exceeds $5.49 million or that you live in a state with an inheritance tax with a much lower exemption level, an ILIT (see above) might well make sense to provide funds for your beneficiaries to pay the taxes owed on the estate.

Bottom Line

Tax laws are incredibly complex and change from year to year. Life insurance policies can often help both you and your beneficiaries avoid taxes, but consult a knowledgeable financial advisor before making any decisions. And when you do, you'll be ready to walk in with confidence, knowing a thing or two about your options.