With very rare exceptions, life insurance proceeds are never taxed as ordinary income. However, they will be taxable as part of an estate. However, with the current estate tax exemption at $5.43 million, most estates will never owe an estate tax at the federal level. You may have to check in whether in fact the state in which the decedent died has an estate or inheritance tax independent of the federal tax. I hope this helps and good luck.
As a beneficiary, life insurance proceeds are not included in your gross income, therefore, do not need to be reported and are not taxed. Since life insurance premiums are typically paid with after-tax dollars (money that has already been taxed), their proceeds are exempt from income tax.
However, life insurance proceeds are taxed if they are paid in installments instead of a lump sum (e.g. Minnesota Life Omega Builder has an option of installments or lump sum due to their living benefit features). The interest paid on the installments is taxed at ordinary income rates.
In regards to estate taxes, the death benefit is included in the deceased's estate (the exemption is $5.45 million per individual in 2016), so it may be subject to federal and state tax if not established under an Irrevocable Life Insurance Trust (ILIT) or if gifted and three years has not passed.
If you have any further questions, I'd be happy to help.
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.)
Life insurance is not exactly tax-free. But that's Okay.
Life insurance is a very popular product because it offers very desirable tax advantages.
With the proper management of the product - and of your estate in general - you can minimize or avoid taxation on both the policy cash accumulation, and the survivor benefit. The key here is proper management, and that takes an understanding of applicable tax laws. Make sure you consult with an attorney who specializes in this field. Errors can be costly.
Having said that, I'll share with you what I have learned in 25 years of selling the product. I'll give you an overview of how benefits can be taxable, in very general terms. You can decide with your advisor what applies to you. (Of course, none of this overshadows the fact that life insurance remains a uniquely valuable way to secure the financial health of your family, business, and favorite charity.)
Here are ways your life insurance benefits could be taxed:
1. Withdraw too much from your universal life policy.
If you withdraw an amount greater than your total premiums paid, the policy gain – the difference between the cash value and the total premiums paid – could be reported as taxable.
Same problem if you surrender the policy.
2. Terminate your cash value policy with outstanding loans.
If the policy is in force when the claim is filed, then the outstanding loan plus interest will be deducted from the death benefit. No penalty, no tax. But if you surrender or lapse the policy, then the loan can be considered a taxable distribution.
3. Receive dividends greater than your total premiums.
Participating policies can pay substantial dividends to policy owners. These dividends are received tax free – until the total declared exceeds the total premiums paid.
4. Choose the “accumulate dividends at interest” option.
If you own permanent life insurance and choose this option, then the interest earned on the dividend accumulated can be taxable in the year credited.
5. Over-fund your life insurance.
To be considered life insurance and thus qualify for tax deferral, a policy must meet certain IRS limits for cash accumulation. If those limits are exceeded through the payments of premiums, dividends, or interest, both the cash accumulation and the death benefit can be taxable. Similarly, the earnings of a Modified Endowment Contract can be taxable.
6. Select a payment schedule as the death benefit settlement.
Beneficiaries can receive their money in a lump sum, or in periodic payments. If you want the carrier to distribute the money in payments over time, then the interest earned on the remaining principal can be taxable.
7. Put life insurance inside a qualified retirement plan.
For sure, doing so can give both the employer and the employee desirable tax benefits and underwriting concessions. However, a portion of the benefit must be reported as income according to IRS tables. Policy cash values can also be taxable.
8. Use a split dollar arrangement to buy life insurance.
As with a qualified plan, a split dollar arrangement provides very desirable perks. Nonetheless, a portion of the benefit should be reported as income according to IRS tables.
9. Collect on a policy kept on a former employee.
If an employer retains a policy on an employee that left the firm, the benefit could be taxable.
10. Retain an incidence of ownership in a policy when you have a large estate.
The amount of insurance will increase the size of your estate, and thus possibly become taxable at both the federal and state levels.
11. Assign only part of your policy over to your favorite charity as a gift.
To be tax-deductible, a gift must be total and absolute. This means you must hand over all incidents of ownership. Simply naming the charity as a beneficiary is not sufficient to qualify for the tax deduction.
12. Transfer your policy for value.
The IRS identifies “nonexempt transferees” for whom the benefits could be taxed when received. These include former executives and business partners.