How are life insurance proceeds taxed?
Life insurance death benefits proceeds are generally tax free. If benefits are paid out in a lump sum this amount is not included in gross income. Any interest received is taxable.
Keep in mind, the death benefit amount is included in the estate of the deceased. Therefore, the estate may be subject to estate taxes both at the federal and state levels. If the owner of the life insurance is someone other than the decrease then the amount is not included within the deceased estate. However, this type of policy structure has to incur more than 3 years prior to the date of death or the amount will be included in the policy owner’s estate for tax purposes.
Generally, life insurance death benefits that are paid out to a beneficiary in lump sum are not included as income to the recipient of the life insurance payout. This tax-free exclusion also covers death benefits payment made under endowment contracts, worker's compensation insurance contracts, employer's group plans or accident and health insurance contracts.
If a policy is combined with a non-refund life annuity contract where a single premium is equal to the face value of the insurance is paid, then the exclusion does not apply. If the death benefit face value is $250,000 (for example), and the beneficiary elects to receive monthly payments instead of the lump sum amount, the additional interest received above the $250,000 face amount is taxable.
While life insurance death benefits are generally excluded from income tax to the beneficiary, they are included as part of the estate of the deceased if the deceased was the owner of the policy at the time of death. This inclusion as part of the estate may subject the benefit paid to estate taxes both at the federal and state levels. Estate inclusion can be avoided if the owner of the life insurance policy is someone other than the deceased, however; this assignment must have occurred more than three years prior to the date of death, or the IRS will still consider the deceased as the policy owner for estate tax purposes. (Learn how to cut your tax bill while building wealth in Cut Your Tax Bill With Permanent Life Insurance.)