Do beneficiaries pay taxes on life insurance?
Generally, the death benefit of a life insurance is tax-free to the beneficiary. However, another big exception to this is on life insurance policies where the owner and beneficiary is a corporation and the premium payments were tax deductible to the company. In some of these scenarios, the death benefit on the policy may be taxable.
Generally speaking, when the beneficiary of a life insurance policy receives the death benefit, this money is not counted as taxable income, and the beneficiary does not have to pay taxes on it. However, a few situations exist in which the beneficiary is taxed on some or all of a policy's proceeds. If the policyholder elects not to have the benefit paid out immediately upon his death but instead held by the insurance company for a given period of time, the beneficiary may have to pay taxes on the interest generated during that period. When a death benefit is paid to an estate, the person or persons inheriting the estate may have to pay estate taxes on it.
Income earned in the form of interest is almost always taxable at some point. Life insurance is no exception. This means when a beneficiary receives life insurance proceeds after a period of interest accumulation rather than immediately upon the policyholder's death, he must pay taxes, not on the entire benefit, but on the interest. For example, if the death benefit is $500,000, but it earned 10% interest for one year before being paid out, the beneficiary owes taxes on the $50,000 growth.
Estate and Inheritance Taxes
In some cases, life insurance proceeds are paid to the estate of the deceased. This most often happens when the policy's beneficiary precedes the policyholder in death and no contingent beneficiary is named. The death benefit adds to the value of the estate, which may be subject to estate taxes or inheritance taxes. The easiest way to avoid this situation is to name a primary and contingent beneficiary to a life insurance policy.
It's always a good idea to get tax advice from a tax professional. Having said that, I can share some lessons learned from my 25 years experience in the life insurance business.
I think on virtually every claim I have helped file, the beneficiary has taken the benefit in a lump sum. No income tax there. If they had let the company hold on to the money, and distribute it as monthly income, they would've had to pay tax on the interest earned. Then again, they would've had the same obligation had they received a lump sum and invested it in a taxable investment to generate monthly income.
If you want to get really clever about this, you could do the following: take a lump sum life insurance benefit, and put it into a new life insurance policy on yourself. If you play your cards right, it could both accumulate tax-deferred and be distributed tax-free. Of course, you have to need the life insurance, qualify for a good rate, etc. Make sure you know what you're doing here.
Another way to get taxed on the life insurance benefit is to receive money from an estate that is so large, the unified credit won’t shield all its assets. This is an estate tax, not an income tax. With proper estate planning, you can avoid this. (I personally can't wait until the estate tax is repealed so we don't have to worry about that burden. This may seem like blasphemy coming from a guy who makes money selling life insurance to pay estate taxes; but frankly, I don't think the government has any right to my family's money that was already taxed upside down and sideways when earned.)
Just a little political commentary, as long as we are on the topic :)
The law basically says that life insurance proceeds are received income tax-free by the beneficiary. However, there are a couple possibilities were a beneficiary of life insurance proceeds may be responsible for a portion of the estate tax, if in fact there is one due. As an example, a will can provide for what's called an "apportionment clause" and a good example of this might be a statement in the will that says that if there's any estate taxes due, they will be paid proportionally by the beneficiaries who receive the assets from the estate. Under this set of circumstances, there would be an estate tax due but not an income tax. It is possible that some income tax may be due when the life insurance company takes its time in delivering the proceeds of the policy to the beneficiary. The face amount of the policy, let's say it's $25,000, is received income tax-free. However, the law requires the insurance company to pay interest to the beneficiary from the date of death until they pay out the proceeds. Let's assume that the beneficiaries you $25,030. The $30 would represent interest income and that's $30 would be reportable in the year the proceeds are received as taxable income to the beneficiary. I hope this helps and good luck
In general, beneficiaries of a life insurance do not pay taxes. But, (yes, there’s always a “but”), under some circumstances (you may never heard before), you may have to pay some tax if you are inheriting a big estate. Seems that right now (2016) we’re settled with a big exempt amount of $5.45 million per individual, or $10.9 million per couple, but who can be certain that the future of the estate tax won’s change? For the longest time, this was a touchy & uncertain topic. When short on money, the politicians can always change back to a lower amount, $1 million or less to get the tax money. Should that happen, you bet that any estate balance over the threshold of $1 million, which the life insurance proceeds are a part of the estate tally, will be taxable. If you foresee that happening to you in the future, you may want to ask your estate planning attorney to possibly set up an ILIT (Irrevocable Life Insurance Trust), which keeps the insurance proceeds from becoming part of your estate. However, be warned that even with such a tactic, if you transfer the policy to the ILIT less than three years before the death, it would still be subject to the estate tax. So, proactive planning is the key. Best!