There are three ways to receive funds from life insurance. The first is through the death benefit. The second is by borrowing from the policy, and the third is cash surrendering a policy. There are also two types of taxation that life insurance may trigger: income tax and estate tax. In North Carolina, the rules for taxation of life insurance follow the federal rules on life insurance taxation.
Death Benefit and Income Tax
If you're a beneficiary of a life insurance policy, you pay no federal or North Carolina income tax on the amount you receive. There is an exception if you receive interest on the policy. The interest may occur because of a delay in filing a claim or because the beneficiary chose installment payments. Interest, not the actual death benefit, receives taxation.
If you cash surrender a policy and receive more back than you paid in premiums, you'll pay taxes on the amount that's more. The insurance company will send you Form 1099-R. On the federal income tax form, you list this amount on the line for pensions and annuities. Since North Carolina uses the federal taxable income for its tax base, that amount is already included when you transfer your income to North Carolina's D400 tax form.
Normally, you don't pay federal or North Carolina taxes when you borrow from a life insurance policy. If you die, the company subtracts the money from the death benefit, and your heirs don't pay on those funds regardless. However, if you cash surrender a policy or allow it to lapse and the loan plus the cash value left in the policy is more than what you paid in premiums, you'll owe taxes on any amount that's more than the premiums.
The death benefit from life insurance is included in the estate of the deceased, if the deceased owned the policy. However, both North Carolina and the federal government have a $5 million dollar exemption for estates. That means if the estate, including life insurance death benefits, is less than $5 million, there's no estate tax for either North Carolina or the federal government.