Life Insurance: Can The Government Halt Your Payout?

Life insurance payouts are typically not taxed and are not considered gross income, so beneficiaries don't need to report them to the IRS. However, there are certain scenarios where taxes may apply. For example, if the beneficiary is an estate, the death benefit may be subject to estate taxes. Additionally, if the payout is in installments, any interest accrued is taxable. It's important to understand these exceptions to plan for any potential tax liabilities. Consulting with a financial advisor or tax professional can provide guidance based on individual circumstances.

Naming beneficiaries

There are two "levels" of beneficiaries: primary and contingent. A primary beneficiary is your first choice to receive the death benefit if you pass away. A contingent beneficiary is the backup; they are the person you would want to receive the payout if the primary beneficiary is deceased as well. For example, if your spouse is your primary beneficiary and you both pass away in a car crash, the contingent beneficiary would receive the death benefit.

You can choose to name a single beneficiary, or a primary beneficiary and one or more contingent beneficiaries. It is recommended that you inform your loved ones who the beneficiaries are and how much each person is getting ahead of time to avoid any unpleasant surprises.

When choosing a life insurance beneficiary, you can name:

• A person, such as a relative, child, spouse, friend, or anyone else you know.
• A legal guardian of a minor.
• A charitable organization.
• A business.
• A trust.

There are almost no rules restricting who you can pick as your beneficiary. The only real restriction is for minors, as you would need to designate a trust or legal guardian as the beneficiary to provide them the death benefit.

It is important to be specific when designating a beneficiary, as this will make it easier for the life insurance company to find them and reduce the likelihood of disputes arising regarding the death benefits. For example, just saying "husband" or "wife" on a life insurance policy could cause problems if you get divorced and remarried. In this case, the details needed will include the address, social security number, and date of birth.

You can also specify whether a beneficiary should receive the life insurance proceeds as a lump-sum payment or in monthly payments. This method is typically preferred if your beneficiary is a teenager or you wouldn’t necessarily trust them to spend a large influx of cash well.

When the government can withhold

In most cases, life insurance payouts are not taxable and are not considered gross income. However, there are certain scenarios where taxes may apply.

Estate Taxes

If the death benefits are paid to the policyholder's estate instead of a named beneficiary, the payout may become part of the policyholder's taxable estate, potentially subjecting it to estate taxes. In 2024, the federal estate tax ranges from 18% to 40%, depending on how much of the estate is over $13.61 million.

Income Taxes on Interest

If you take an interest-based payout, you will have to pay income taxes on that interest. This also applies to instalment plans, where the money that hasn't been received yet is earning interest, which is then taxed.

When the Beneficiary is an Estate

If your estate is the beneficiary of your life insurance policy, the death benefit may be subject to estate taxes.

When Payment is in Instalments

If you receive a policy payout in instalments rather than as a lump sum, any interest that accrues is taxable. The principal death benefit is still not taxed.

When Withdrawing Money from Cash Value

Both whole life insurance and universal life insurance policies earn interest, referred to as cash value, and policyholders may be able to make withdrawals or take out a loan against the balance. If the withdrawal or loan is more than the total amount of premiums you've paid, the excess can be taxed.

When Surrendering the Policy

If you cancel a whole life or universal life insurance policy, you typically receive the cash surrender value, which is your policy's cash value minus any fees. You don't have to pay taxes on the principal when it's returned, but any cash value your policy has accrued will be taxed as income.

When it's an Employer-Paid Group Life Insurance

If you are receiving proceeds from an employer-paid life insurance policy, any death benefit beyond $50,000 is taxed as income, according to the IRS.

Taxation on payouts

Taxation on life insurance payouts depends on several factors, including the type of policy, the payout structure, and the relationship between the policyholder, insured, and beneficiary. Here are some key considerations:

Lump-Sum vs. Installment Payments

Lump-sum payments are typically tax-free for the beneficiary, regardless of whether the policy is term, whole, or universal life insurance. However, if the payout is structured as multiple payments or an annuity, the interest earned on these payments may be subject to income tax.

Policyholder Withdrawals or Loans

In the case of whole life insurance policies, which accumulate cash value over time, if the policyholder withdraws or borrows money against the policy and does not repay it, the amount withdrawn above the total premiums paid may be taxable.

Employer-Paid Group Life Plans

According to the Internal Revenue Service (IRS), if an employer-paid group life plan pays out more than $50,000, the payout may be taxable. Otherwise, the death benefit is usually paid to beneficiaries tax-free.

Estate Taxes

If the life insurance proceeds are included as part of the deceased's estate and the total value exceeds the federal estate tax threshold (which was $12.92 million in 2023), estate taxes must be paid on the proceeds over the allowed limit.

Interest Income

Any interest income earned on the death benefit before being paid out is generally taxable as income.

Goodman Triangle

In situations where the policyholder, the insured, and the beneficiary are three different people, a gift tax may apply. For example, if a parent (policyholder) takes out a policy on their child (insured) and names their spouse as the beneficiary, the IRS may view the death benefit as a financial gift from the parent to the spouse, triggering a gift tax.

Income Taxes on Interest

If the beneficiary chooses an interest-based payout option, they will typically have to pay income taxes on that interest. Similarly, if they choose an installment plan, the portion of the death benefit that has not yet been paid out earns interest, which is also taxable.

Claiming the payout

The process of claiming a life insurance payout begins with the beneficiary contacting the insurance company. They will need to provide a death certificate and any other necessary documentation to initiate the payout. The death benefit is typically paid out as a lump sum, though some policies may offer other options like instalment payments or an annuity.

Lump-sum payments

Lump-sum payments are the most common and simplest payout option. Beneficiaries receive the entire death benefit in one single, usually tax-free, payment. This provides immediate access to the full amount, which can be crucial for covering significant expenses or debts.

Instalment payments

With an instalment plan, the life insurance company pays the beneficiary a certain amount of money on a regular schedule (usually monthly, quarterly or yearly). This option can provide a steady income stream, making financial planning easier. However, any interest earned on these payments may be taxable.

Retained asset account (RAA)

In this option, the insurer holds the death benefit in an interest-bearing account and provides the beneficiary with a checkbook to draw funds as needed. This offers flexibility and easy access to the funds while earning interest. However, the interest earned may be subject to taxes.

Interest-only payout

With this option, the insurer keeps the death benefit and pays the beneficiary only the interest earned on the amount. The principal remains intact and can be passed on to other beneficiaries upon the original beneficiary's death. This option provides regular income but may come with taxable interest.

Lifetime annuity

A lifetime annuity provides guaranteed payments to the beneficiary for the rest of their life. The amount is determined by the death benefit and the beneficiary's age. If the beneficiary dies before the death benefit is exhausted, the remaining amount typically reverts to the insurer.

Fixed-period annuity

In a fixed-period annuity, the death benefit is paid out over a specified period, such as 10 or 20 years. If the beneficiary dies before the end of this period, their designated beneficiaries can continue to receive the remaining payments. This ensures a regular income for a set time frame.

Claim process

As soon as possible after the policyholder's death, the beneficiary should contact the insurance company to find out their procedure for filing a claim. They will likely need to submit a certified copy of the death certificate and complete additional paperwork, such as a claim form. Although there is no deadline for filing a claim, it is recommended to handle this as soon as possible. Most states allow up to 30 to 60 days for the insurer to review the claim.

If the claim is filed properly and all necessary documents are provided, the beneficiary will typically receive the death benefit payout within a month. However, there are rare circumstances that could cause delays, such as if the policy was purchased recently, suspected foul play, fraud, or if the policyholder was killed during illegal activity.

Choosing a payout structure

Lump-Sum Payment

This is the most common payout option. Beneficiaries receive the entire payout all at once, giving them full control over the money and how they want to use it. However, receiving a large amount of money at once can be overwhelming, and the beneficiary will be responsible for making it last. Additionally, if the payout is large, it may need to be spread across several accounts to ensure it is all protected by FDIC insurance.

Installment Payments

With this option, the life insurance company pays the beneficiary a certain amount of money on a regular schedule (usually monthly, quarterly, or yearly) over a fixed period of time or for their lifetime. This option can provide a steady income stream, making financial planning easier. However, any interest earned on these payments may be taxable.

Retained Asset Account

With this option, the life insurance company holds the payout in an interest-bearing account and provides the beneficiary with a checkbook to draw funds as needed. This option offers flexibility and easy access to the funds while also earning interest. However, the interest earned may be subject to taxes, and the interest rate provided might not be as high as what could be achieved through other investment options.

Lifetime Annuity

A lifetime annuity provides guaranteed payments to the beneficiary for the rest of their life. The amount is determined by the death benefit and the beneficiary's age. If the beneficiary dies before the entire death benefit is paid out, the remaining amount typically reverts to the insurer.

Fixed-Period Annuity

With a fixed-period annuity, the death benefit is paid out over a specified period, such as 10 or 20 years. If the beneficiary dies before the end of this period, their designated beneficiaries can continue to receive the remaining payments. This option ensures a regular income for a set period of time.

When choosing a payout structure, it is important to consider your financial goals and needs, as well as the goals of the policy. It is also a good idea to consult with a financial professional to help you make the best decision for your circumstances.

Frequently asked questions