Life Insurance Death Benefit: Taxable Scenarios And Exemptions

Life insurance death benefits are typically not taxable, but there are several exceptions to this rule. Generally, life insurance proceeds received by a beneficiary due to the death of the insured person are not considered gross income and do not need to be reported. However, any interest accrued on the proceeds is taxable and must be reported. Additionally, if the policy was transferred for cash or other valuable consideration, the exclusion for proceeds may be limited. In certain cases, an employer-paid plan that pays out more than $50,000 may also be subject to taxes. Furthermore, if the death benefit and the total value of the deceased's estate exceed the federal estate tax threshold, estate taxes become applicable.

Interest on the benefit is taxable

Generally, life insurance proceeds that a beneficiary receives due to the death of the insured person are not considered gross income and do not need to be reported as such. However, any interest accrued on the benefit is taxable and must be reported as interest income. This means that the interest growth on the benefit is taxed, rather than the entire death benefit.

If you choose to receive the policy amount in installments, the benefit is placed into an account that can accrue interest. While you will not pay taxes on the benefit itself, you will be responsible for paying income taxes on any interest accrued. For example, if you are the beneficiary of a $500,000 death benefit that earns 10% interest for one year before being paid out, you will owe income taxes on the $50,000 in interest growth.

In the case of a taxable gift, a life insurance death benefit may be subject to taxes. This occurs when three people serve distinct roles in connection to the policy: the policyholder, who purchases the policy and pays premiums; the insured, whose life is covered by the policy; and the beneficiary, who receives the death benefit when the insured passes away. If the beneficiary receives the death benefit, the IRS considers this a taxable gift from the policyholder, and gift taxes may need to be paid if the benefit amount exceeds federal gift tax exemption limits. As of 2023, the annual gift exclusion is $16,000 per individual or $17,000, while the federal estate tax threshold is $12.92 million for a single person and nearly $26 million for a married couple.

Additionally, if the policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds may be limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. There may be strategies to avoid paying taxes on a life insurance payout, such as transferring ownership of the policy to another person or entity, or setting up an irrevocable life insurance trust (ILIT) to own the policy.

Taxable gifts

Life insurance benefits are generally not taxable. However, there are some circumstances in which taxes are assessed. One such scenario is when the death benefit is considered a taxable gift.

A life insurance death benefit is typically paid to the beneficiary as a lump sum, which is not subject to income tax. However, if the beneficiary is someone other than the insured's spouse, the IRS may consider the death benefit a taxable gift from the policyholder to the beneficiary. This is known as the "Goodman Rule" or the "Goodman Triangle". In such cases, the policyholder may have to pay gift taxes if the benefit amount exceeds the federal gift tax exemption limits. The annual gift exclusion is $16,000 per individual in 2022 and $17,000 in 2023.

To avoid potential gift taxes, it is recommended that the owner and the beneficiary or the owner and the insured be the same person. Alternatively, an irrevocable life insurance trust should be the owner and beneficiary of the policy if the goal is to benefit a third party.

Another scenario where a taxable gift may occur is when the policy is subject to a loan. If the policy owner transfers ownership of the policy, they are relieved of the debt, and the transfer is treated as if the policy were sold. Consequently, the donor will recognize taxable income if the loan exceeds their basis.

Estate taxes

Life insurance proceeds are generally not taxable. However, there are certain exceptions to this rule. One such exception is estate taxes.

To avoid estate taxes, you can name an individual as the beneficiary of your policy rather than your estate. This ensures that the payout goes directly to your chosen beneficiary and is not subject to probate or estate taxes. Another option is to create an irrevocable life insurance trust (ILIT) and designate the trust as the beneficiary. By doing so, you can separate the payout from your estate and ensure that the funds are distributed according to your wishes.

It is worth noting that, while estate taxes typically apply to the total value of the estate, beneficiaries may only need to pay taxes on the interest generated by the proceeds if the policyholder delays the benefit payout. In this case, the interest accrued is considered taxable income, and the beneficiary will only be taxed on the growth of the benefit rather than the entire death benefit.

Policy transferred for cash

Generally, life insurance proceeds received by a beneficiary due to the death of the insured are not taxable. However, there are certain situations where the proceeds may be taxable. One such situation is when the policy is transferred for cash or other valuable consideration. In this case, the exclusion for the proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts.

When a life insurance policy is transferred for cash, the transfer may trigger tax implications for the beneficiary. The tax consequences will depend on the specifics of the transfer, including the amount of cash or other consideration involved, the timing of the transfer, and the applicable tax laws.

If the policy is transferred for cash before the death of the insured, the transfer may be considered a sale of the policy. In this case, the proceeds received by the beneficiary may be taxable as income. The beneficiary may be required to report the proceeds as income and pay taxes on them. However, if the beneficiary has a cost basis in the policy (such as premiums paid), they may be able to reduce the taxable amount by the cost basis.

On the other hand, if the policy is transferred for cash after the death of the insured, the proceeds received by the beneficiary may still be exempt from income tax. However, if the beneficiary receives the proceeds in installments, any interest accrued on the unpaid portion may be taxable as income. Additionally, if the beneficiary is not a named individual but an estate, the proceeds may be subject to estate taxes if the value of the estate exceeds the exemption threshold.

It is important to note that the tax implications of transferring a life insurance policy for cash can be complex and may depend on various factors. As such, it is always recommended to consult with a tax professional or financial advisor to understand the specific tax consequences of any policy transfers or other transactions involving life insurance.

Employer-paid plans

Generally, death benefits from life insurance policies are not subject to ordinary income tax. However, there are certain scenarios where employer-paid plans may be taxed.

If you have life insurance through your employer, the benefits are usually not taxable if the coverage amount is less than $50,000. According to the IRS, if the death benefit exceeds $50,000, the portion of the premiums paid by your employer for coverage above $50,000 is subject to income taxes. This means that if your employer-provided coverage is worth more than $50,000, you may have to pay taxes on the excess amount.

In addition, if you pay the premiums of a health or accident insurance plan through a cafeteria plan and treat the premium amount as non-taxable income, the benefits you receive are fully taxable. This means that if your employer offers a cafeteria plan for insurance and you opt to pay the premiums with pre-tax dollars, any disability or life insurance benefits you receive through this plan will be taxable.

It is important to note that if you have a whole life insurance policy, you may owe income tax if you sell, surrender, or withdraw/borrow against the policy's cash value. This is separate from any death benefits that may be paid out to beneficiaries.

To avoid unexpected tax liabilities, it is always recommended to consult with a tax professional or financial advisor who can provide guidance based on your specific circumstances. They can help you navigate the complexities of insurance and ensure you understand the tax implications of your employer-paid plans.

Frequently asked questions