Life Insurance Benefits: Interest Accrual After Death?

Life insurance is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person passes away. In most cases, the death benefit from a life insurance policy is not considered taxable income by the IRS. However, the question of whether life insurance benefits collect interest from the date of death is a complex one. In the US, the Internal Revenue Service (IRS) states that any interest received by the beneficiary is taxable and should be reported. In the state of New York, interest begins to accrue from the date of death of an insured person, not from the date that the claim is filed with the life insurer. This means that in New York, life insurance benefits do collect interest from the date of death. The interest rate is determined by the rate in effect on the date of death, and it is subject to fluctuations during the period between death and the date of payment.

Interest accrual on life insurance benefits

In the context of life insurance benefits, interest accrual can occur in a few different scenarios. One common scenario is when there is a delay between the insured's death and the payout to the beneficiary. In such cases, interest may accrue on the death benefit from the date of death until the date of payment. This is specified in the insurance laws of certain states, such as New York, which states that interest on life insurance proceeds should be computed from the date of death to the date of payment. This ensures that beneficiaries receive the full value of the benefit, even if there are delays in processing the claim.

Another scenario where interest accrual may come into play is when the beneficiary chooses a specific income payout option. In this case, the insurance company places the death benefit into an interest-bearing account, and the beneficiary receives regular payments over time. The interest earned on this account is typically subject to taxation, and beneficiaries should consider the potential tax implications when choosing this option.

Additionally, some life insurance policies offer both death and living benefits, allowing the policyholder to access a portion of the death benefit while they are still alive. In these cases, interest may accrue on the remaining balance of the death benefit, and this interest may be taxable for the beneficiary upon payout.

It is important to note that the specific rules and regulations regarding interest accrual on life insurance benefits can vary by state and insurance provider. Therefore, it is always advisable to carefully review the terms and conditions of your life insurance policy and consult with a financial advisor or tax professional to understand the potential tax implications of any interest accrual.

Tax implications of life insurance benefits

Life insurance benefits are generally not taxable. However, there are certain scenarios where taxes may apply.

Interest Income

If the life insurance benefit accrues interest before being paid out, the interest portion is taxable as income. In New York, for example, interest begins to accrue from the date of death of the insured, not from the date that the claim is filed with the life insurer. The interest rate would be determined by the rate in effect as of the date of death, and it would be calculated by whatever rate is in effect on each day under the interest settlement option, from the date of death to the date of payment.

Goodman Triangle

If the policyholder, the insured, and the beneficiary are three different people, the death benefit may be considered a gift from the policyholder to the beneficiary. This may trigger a gift tax because the IRS views it as the policyholder giving a financial gift to the beneficiary.

Estate Tax

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.

Policy Transfer

If the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. There are some exceptions to this rule. Generally, you report the taxable amount based on the type of income document you receive, such as a Form 1099-INT or Form 1099-R.

Retirement Rules and Distribution Requirements

It is important to note that retirement rules and distribution requirements can be changed by the government over time. Life insurance can play a role in a financial strategy that offers different types of income tax advantages.

Choosing a life insurance beneficiary

Who Can Be a Life Insurance Beneficiary?

Almost anyone can be a life insurance beneficiary, including people, organisations, and trusts. Some common examples include a spouse, children, a charitable organisation, or a legal entity like your company. However, if you live in a community property state, your spouse may need to waive their rights if you want to designate someone else as a beneficiary.

Primary vs. Contingent Beneficiaries

Primary beneficiaries are the first in line to receive the death benefit if you die. Contingent beneficiaries, or secondary beneficiaries, will receive the benefit if the primary beneficiary dies before you do. You can have multiple primary and contingent beneficiaries and decide how much of the payout each party receives.

Irrevocable vs. Revocable Beneficiaries

An irrevocable beneficiary designation cannot be changed without the beneficiary's approval. This provides assurance that the death benefit will reach a specific person but offers less flexibility. On the other hand, a revocable beneficiary can be changed, updated, or removed at any time, allowing you to update your designation as needed.

Naming Children as Beneficiaries

Naming your children as beneficiaries can be complicated if they are minors. Options include appointing a legal guardian to receive payouts on their behalf or setting up a trust for them and having a trustee oversee and distribute the funds according to your wishes.

Notifying Beneficiaries

While not a legal requirement, it is recommended to notify your beneficiaries and provide them with a copy of your life insurance policy. This ensures they are aware of the policy and can file a claim when the time comes.

Choosing the Right Beneficiary

Ask yourself why you have life insurance. Who relies on you financially, and who would need financial support to cover costs incurred by your death? Be as specific as possible when designating beneficiaries, including their full name, Social Security number, relationship to you, date of birth, and address. Consult a legal professional to ensure you use the correct language.

Claiming a life insurance benefit

Collect Important Documents:

• Obtain several copies of the death certificate. You can request these from the funeral home, medical professional who confirmed the death, or your local vital records office.
• Locate the policy document, which includes information such as the policy number, death benefit amount, and beneficiary names. Contact the insurance company or the deceased's financial representatives if you need assistance.
• Complete the claim form, also known as a "request for benefits." Here, you'll provide details about the policyholder, cause of death, your relationship to the policyholder, and your preferred method for receiving the death benefit.

Contact the Insurance Company:

Reach out to the insurance company that issued the policy to notify them of the death and file your claim. You can do this directly or through your insurance agent, who can guide and support you through the process.

Wait for the Claim to be Processed:

• The insurance company will verify that the policy is still active and confirm your identity as the beneficiary. They may request additional paperwork if needed.
• The processing time can vary, but insurers are incentivized to pay out quickly to avoid interest charges on unpaid death benefits. Check with the insurance company and your state regulations to understand their deadline.

Receive the Death Benefit:

• There are several ways to receive the death benefit, depending on the insurance company and the specific policy. The two most common options are a lump sum or an annuity.
• A lump sum pays out the entire death benefit at once, and it is typically tax-free.
• An annuity invests the death benefit and pays it back in annual installments over a set number of years, starting in the future. You will owe taxes on the investment gains.

It's important to note that there is no time limit for filing a life insurance claim. However, it is advisable to initiate the process as soon as possible to expedite receiving the death benefit.

Life insurance payout options

Life insurance provides financial security for families after the death of a provider. The death benefit is paid out to the beneficiaries, who can choose from several options for receiving the payout.

Lump-Sum Payment

The most common option is for beneficiaries to receive the entire death benefit in a single, usually tax-free payment. This provides immediate access to the full amount, which can be crucial for covering significant expenses or debts.

Installment Payments

Beneficiaries can also choose to receive the death benefit in installments over a fixed period 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 (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 method ensures a regular income for a set time frame.

Frequently asked questions