Life Insurance Death Benefits: What Taxes Are Due?

Life insurance death benefits are typically not subject to ordinary income tax. However, there are certain circumstances where beneficiaries may be exposed to tax liability. For example, if the beneficiary receives the death benefit in installments that include interest, then the interest will be taxable. Additionally, if the beneficiary is the policyowner's estate, the death benefit may be subject to estate taxes. In some cases, if the insured, policy owner, and beneficiary are different individuals, gift tax may be applicable.

Death benefits are typically tax-free

Death benefits from life insurance policies are typically tax-free. However, there are some exceptions to this rule.

If you receive the death benefit in instalments, any interest that accrues is taxable. The principal death benefit is still not taxed. If your estate is the beneficiary of your life insurance policy, the death benefit may be subject 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, the exclusion limit. Twelve states and the District of Columbia also impose an estate tax, with the exemption limit ranging from $1 million in Oregon to $13.61 million in Connecticut.

If the policyholder chose their estate as a life insurance beneficiary, taxes might apply. The taxes loved ones may pay depend on the estate's value. The person who buys a life insurance policy is usually considered the owner and insured. However, if a different person holds each role, there may be taxes involved.

There are some strategies beneficiaries can use to avoid paying taxes on a life insurance payout. 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. If you set up an irrevocable life insurance trust (ILIT), it will own the life insurance policy rather than you.

Additionally, if the insured is a different person than the policy owner, the IRS will conclude that the death benefit amount from the policy owner to the beneficiary, and you may have to pay gift tax on the amount. Once the insured has died, the gift tax comes due, but the beneficiary of the death benefit won't have to pay it unless it is more than the exemption amount. If you die within three years of a transfer of ownership, the full amount of the proceeds is included in your estate as though you still owned the policy.

Interest accrued on the policy is taxable

Generally, death benefits from life insurance policies are not subject to ordinary income tax. However, interest accrued on the policy is taxable. This means that if the beneficiary receives the death benefit in installments that include interest, the interest will be taxed. The interest is calculated from the date of the insured's death to the date the insurance company sends the death benefit check to the beneficiary. The insurance company reports the interest to the Internal Revenue Service (IRS), and the beneficiary must report it as interest received.

If the beneficiary of a life insurance policy receives proceeds that have accumulated some interest, they will usually need to pay taxes on the interest. The taxable amount is based on the type of income document received, such as a Form 1099-INT or Form 1099-R. It's important to note that the entire death benefit is not taxed, only the interest earned.

In certain cases, if the policyholder does not name a beneficiary, the insurer may pay the proceeds to the estate of the insured. In such cases, the death benefit may be subject to federal or state estate tax if it exceeds the estate tax exemption limit. Additionally, annuity beneficiaries may pay income tax on death benefits, while life insurance beneficiaries generally do not.

It's worth mentioning that there are strategies beneficiaries can use to avoid paying taxes on a life insurance payout. For example, transferring ownership of the policy to another person or entity before the insured passes away can help avoid taxation. Setting up an irrevocable life insurance trust (ILIT) ensures that the trust owns the life insurance policy rather than the individual.

While the focus here is on the taxation of interest accrued on life insurance policies, it's important to consult a tax advisor or refer to specific IRS guidelines for a comprehensive understanding of the tax implications of life insurance proceeds and interest.

Estate tax may apply if the beneficiary is the policyholder's estate

Generally, death benefits from life insurance policies are not subject to ordinary income tax. However, if the beneficiary is the policyholder's estate, the death benefit may be subject to federal or state estate tax. This is because the death benefit payout becomes part of the estate, increasing its value and, consequently, the estate taxes.

The estate tax only applies if the death benefit paid to the estate, together with the value of the estate, exceeds the federal estate tax threshold. As of 2023, the Internal Revenue Service (IRS) considers death benefits from life insurance to be part of the deceased's estate if the total amount exceeds $12.92 million. In such cases, estate taxes must be paid on the proceeds over the allowed limit.

It is important to note that the size of the estate, the type of policy, and the mode of payment to the beneficiaries are determining factors in whether estate tax applies. For example, if the policyholder delays the payout and the insurance company holds the money, allowing it to generate interest, that interest may be subject to tax. Similarly, if beneficiaries choose to receive the payout as an annuity, or a series of payments, instead of a lump sum, the interest accrued may be taxable.

To avoid paying estate taxes on life insurance proceeds, policyholders can transfer ownership of the policy to another person or entity. Alternatively, they can set up an irrevocable life insurance trust (ILIT) to own the life insurance policy. In this case, the proceeds are not included as part of the estate, reducing potential tax liabilities for beneficiaries.

Gift tax may apply if the insured, policy owner, and beneficiary are different people

Generally, death benefits from life insurance policies are not subject to ordinary income tax. However, if the insured, policy owner, and beneficiary are different people, gift taxes may apply. This scenario is often referred to as the "Goodman Triangle" or governed by the "Goodman Rule".

In this case, the death benefit is typically treated as a taxable gift from the policy owner to the beneficiary. The gift tax is based on the death benefit rather than the policy's cash value. For example, if a parent transfers their life insurance policy to one child and requests that all siblings remain as beneficiaries, gift taxes may be incurred. The child who owns the policy may have to pay gift taxes when they give the policy proceeds to their siblings.

To avoid potential gift taxes, it is recommended that either the owner and the beneficiary or the owner and the insured be the same person. One strategy is to set up an irrevocable life insurance trust, which becomes the owner and beneficiary of the policy. This way, the death benefit is treated as taxable compensation of the employee or as a dividend of a shareholder, rather than a gift.

It is important to note that gifts of life insurance policies made within three years of death are typically disallowed for federal and state estate tax purposes. Therefore, if one wishes to give away a life insurance policy to reduce estate taxes, it is advisable to do so as soon as possible.

Proceeds are taxable if the policy was transferred for cash or other valuable consideration

Generally, life insurance proceeds are not taxable if you are a beneficiary receiving them due to the death of the insured person. However, if a life insurance policy was transferred to you for cash or other valuable consideration, the proceeds are taxable. This means that the exclusion for the proceeds is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts.

A pledge or assignment of a life insurance policy as collateral security for a loan or other obligation owed by the policy owner is not a transfer for valuable consideration. In this case, the proceeds are generally income tax-free to the extent of the outstanding debt amount. However, insurance proceeds representing interest on the debt are taxed as ordinary income to the creditor.

Term life insurance policies are subject to the transfer-for-value rule, even though they do not accumulate cash value. A transfer of some or all of the underlying interest in the policy, such as the death benefit proceeds, is sufficient to invoke the transfer-for-value rule. This means that if you receive a policy through such a transfer, the proceeds will be subject to income tax.

There are, however, some exceptions to the transfer-for-value rule. Life insurance proceeds are received income tax-free, even if there has been a transfer for valuable consideration of a policy or an interest in a policy, if the transfer is:

• To the insured's spouse
• To a partnership in which the insured is a partner
• To a corporation in which the insured is a shareholder or officer
• To a trustee of a trust created by the insured or the insured's spouse
• By way of bequest from the insured to the beneficiary

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