When Is Life Insurance Taxable to Beneficiaries?

When beneficiaries receive a payout from a life insurance policy, they typically don’t have to pay taxes. However, there are a few situations where a portion of the life insurance benefit is taxable to the beneficiary.

When people purchase life insurance policies, they designate a beneficiary who will benefit from the policy’s proceeds. When the policyholder dies, the policy’s beneficiary then receives a payout known as the death benefit.

The primary advantage of life insurance is that beneficiaries can receive substantial lump sum payments without taxation, unless the payout pushes your estate above the applicable federal estate tax exemption, in which case your estate will need to pay the tax.

While death benefits are usually tax-free, there are a few situations where the beneficiary of a life insurance policy may have to pay taxes on the lump sum payout:

Interest Accumulation: When you earn income from interest, it’s typically taxable. If the beneficiary decides to delay the payout instead of receiving it right away, the death benefit may continue to accumulate interest. The death benefit won’t be taxed, but the beneficiary will typically pay taxes on the additional interest.

Estate as Beneficiary: If a life insurance policyholder names their estate as the death benefit beneficiary, the estate could be subject to taxation. When you don’t designate a person as your beneficiary, the proceeds from the life insurance policy are subject to Section 2024 of the IRS code.

No Contingent Beneficiaries: The proceeds of a life insurance policy may also pass to the estate if the beneficiary dies and there are no contingent beneficiaries. If you have a will in place, the proceeds will be paid out according to the terms of the will. If there’s no will in place, the probate court decides how to distribute your assets.

Gift Tax Considerations: A gift tax may apply if the insured, the policyholder, and the beneficiary are three different parties. The IRS assumes the death benefit was a gift from the policyholder to the beneficiary, which might require paying gift taxes on the death benefit.

Beneficiaries usually won’t have to pay taxes on proceeds. However, some situations can result in a taxable event. Be sure that your beneficiary designations are clearly outlined in the policy to avoid taxation.

If you or a loved one needs assistance with elder law, probate or estate planning issues, do not hesitate to book a call with us today. We are here to help.