Beneficiary Life Insurance: Taxable Or Not?

Life insurance payouts are generally not taxable, but there are certain exceptions. The type of policy, the size of the estate, and the method of payment can determine whether or not life insurance proceeds are taxed. If the beneficiary receives the payout as a lump sum, it is typically tax-free. However, if the payout is structured as multiple payments, the interest accrued may be subject to taxes. Additionally, if the policyholder has withdrawn money or taken out a loan against the policy, and the amount withdrawn exceeds the total premiums paid, the excess may be taxable.

Are life insurance proceeds taxable?

Life insurance payouts are generally not taxable, but there are certain exceptions. The type of policy, the size of the estate, and how the benefit is paid out can determine if life insurance proceeds are taxable.

If the life insurance policy goes into an estate: If the policy doesn't name any beneficiaries, the proceeds may be included in the deceased's estate. If the value exceeds the federal estate tax threshold, which was $13.61 million as of 2024, estate taxes must be paid on the amount over the limit. Some states also assess inheritance or estate taxes, depending on the estate's value and the deceased's residence.

Choosing to receive the death benefit as an annuity: If a beneficiary chooses to receive their payout as an annuity (a series of payments over several years) instead of a lump sum, any interest accrued by the annuity account may be subject to taxes.

Withdrawing or taking out a loan against your whole life policy's cash value: If you withdraw more than your cumulative premium payments, you may have to pay income taxes on the excess. Similarly, if you borrow against the cash value and the loan is still outstanding when the policy is terminated or surrendered, the loan amount in excess of the cumulative premiums may be subject to income taxes.

Surrendering or selling your whole life insurance policy: If you surrender or sell your policy and the proceeds exceed the cumulative premiums, the excess may be subject to income taxes.

How to avoid paying taxes on life insurance proceeds

There are some strategies that beneficiaries can use to avoid paying taxes on a life insurance payout, such as:

• Using an ownership transfer: When an estate is involved, whether life insurance proceeds are taxable is based on the policy's ownership when the insured passes away. To avoid taxation, you can transfer ownership of your policy to another person or entity.
• Creating an irrevocable life insurance trust (ILIT): An ILIT owns the life insurance policy, so the proceeds will not be included in your estate. You can state how you'd like the beneficiaries to receive or use the payout.

It is important to consult a financial advisor when shopping for the best life insurance to avoid unexpected tax consequences for your family.

When might a beneficiary pay taxes on insurance?

Generally, a beneficiary does not have to pay taxes on the proceeds of a life insurance policy. However, there are some instances where they may have to pay federal or state taxes.

When the Policy Accrues Interest

If the life insurance proceeds have accumulated some interest, taxes are usually due. In this case, only the amount that earned interest will be taxed, rather than the entire death benefit.

When the Policyholder Names Their Estate as a Beneficiary

If the policyholder chooses their estate as a life insurance beneficiary, taxes may apply. The amount of tax will depend on the estate's value.

When the Policy is Included in the Deceased's Estate

If the policy doesn't have any named beneficiaries, the life insurance proceeds may be included in the deceased's estate. If the value of the estate exceeds the federal estate tax threshold, estate taxes must be paid on the amount that is over the limit. The federal estate tax threshold was $13.61 million as of 2024, and \$12.92 million in 2023. Some states also assess inheritance or estate taxes, depending on the estate's value and where the deceased lived.

When the Policy is Paid Out in Installments

If a beneficiary chooses to receive their payout in installments over several years instead of a lump sum, any interest accrued by the annuity account may be subject to taxes.

When the Insured and the Policy Owner are Different Individuals

If a different person holds each role, there may be taxes involved.

How to avoid paying taxes on a life insurance payout?

Life insurance death benefits are typically tax-free, but there are exceptions. Here are some ways to avoid paying taxes on a life insurance payout:

Choose a lump-sum payout

If you are a beneficiary, opting for a lump-sum payout keeps the death benefit income tax-free. Avoid taxable interest by steering clear of installment payments.

Avoid the Goodman Triangle

Prevent gift taxes by making the insured and owner or the owner and beneficiary the same person.

Use an irrevocable life insurance trust (ILIT)

An ILIT keeps the death benefit out of your taxable estate if certain rules are met. Ensure the policy is transferred to the ILIT at least three years before death.

Keep policy loans in check

Prevent taxable income from policy loans by monitoring your loan balance and ensuring the policy doesn't lapse.

Transfer ownership early

Keep the policy out of your taxable estate by transferring policy ownership well in advance (more than three years before death). Choose a competent adult/entity to be the new owner, and be aware that you will give up all rights to make changes to the policy in the future.

Review beneficiaries regularly

Ensure that your estate isn't named as the beneficiary, and name a contingent beneficiary, to prevent estate taxes. Regularly review and update beneficiaries as life changes occur.

What is the tax rate on life insurance?

There is no specific tax rate for life insurance. The Internal Revenue Service (IRS) considers life insurance proceeds to be generally non-taxable income. However, there are certain scenarios where taxes may apply. Here are some instances where beneficiaries might need to pay taxes on life insurance proceeds:

• Interest accrued on the policy: If the life insurance proceeds accumulate interest, taxes are typically due on the interest earned, rather than the entire death benefit.
• Policyholder names the estate as a beneficiary: If the policyholder chooses their estate as the beneficiary, taxes may apply depending on the estate's value.
• Different insured and policy owner: If the person who buys the policy (policy owner) is not the insured person, there may be tax implications.
• Payout structure: While lump-sum payouts are generally tax-free, if the payout is structured as multiple payments, these can be subject to taxes. For example, if a beneficiary chooses to receive the death benefit as an annuity (regular payments over several years), the interest accrued in the annuity account is considered taxable income.
• Withdrawal or loan against the policy's cash value: If the policy owner withdraws more money than they have paid in cumulative premium payments, or takes out a loan against the policy's cash value, they may have to pay income taxes on the excess amount.
• Surrendering or selling the policy: If the policy owner surrenders or sells their whole life insurance policy and the proceeds exceed the cumulative premiums, the excess amount may be subject to income taxes.
• Employer-paid group life plan: According to the IRS, if the death benefit from an employer-paid group life plan exceeds $50,000, the premiums for coverage over that amount are subject to income taxes.
• Estate taxes: If life insurance proceeds are included as part of the deceased's estate and the total value exceeds the federal estate tax threshold ($12.92 million as of 2023, or $13.61 million as of 2024), estate taxes must be paid on the amount over the limit. Some states also have their own inheritance or estate taxes, depending on the estate's value and location.

It is important to consult with a tax advisor or financial professional to understand the specific tax implications of your life insurance policy.

How to report life insurance proceeds?

Life insurance proceeds are generally not taxable as income, but there are certain scenarios where you may have to pay federal or state taxes. Here is a step-by-step guide on how to report life insurance proceeds:

Step 1: Understand the Different Types of Life Insurance Proceeds

There are two main types of life insurance proceeds: taxable and nontaxable. Taxable proceeds are those that may be subject to federal or state income taxes, while nontaxable proceeds are generally exempt from taxation. Examples of taxable proceeds include interest accrued on the policy and proceeds from a policy transferred for cash or other valuable consideration. Nontaxable proceeds typically include death benefits paid out as a lump sum to the beneficiary due to the insured person's death.

Step 2: Gather Information

To determine if your life insurance proceeds are taxable, you will need to gather specific information. This includes details such as whether you are the policyholder or the beneficiary, the face amount of the policy, the timing and method of payout (lump sum or installments), and whether any federal income tax was withheld from the proceeds.

Step 3: Understand the Tax Implications

If you are the beneficiary of a life insurance policy and receive a death benefit due to the insured person's death, this money is generally not considered taxable gross income and does not need to be reported. However, if the payout is delayed and the insurance company holds the money for a period of time, you may have to pay taxes on the interest generated. Additionally, if the policy is payable to an estate rather than an individual beneficiary, the value of the proceeds may be included in the estate's value, potentially triggering estate taxes.

Step 4: Consult Official Sources and Seek Professional Advice

For detailed instructions on reporting life insurance proceeds, it is essential to refer to official sources, such as the Internal Revenue Service (IRS) website or publications. The IRS provides interactive tools, forms, and instructions to help taxpayers determine the taxability of their specific situation. Additionally, consulting a tax advisor or accountant is advisable, as they can provide personalized guidance based on your unique circumstances.

Step 5: Report Taxable Income and Pay Taxes

If, based on the information gathered and official sources consulted, you determine that your life insurance proceeds are taxable, you will need to report them on your tax return. The specific form to use for reporting taxable income will depend on the nature of the proceeds and the type of income document you receive (e.g., Form 1099-INT or Form 1099-R). Ensure you meet all documentation and reporting requirements in a timely manner to minimize associated taxes.

Frequently asked questions