Generally, life insurance death benefits that are paid out to a beneficiary in a lump sum are not included as income to the recipient of the life insurance payout. This tax-free exclusion also covers death benefit payments made under endowment contracts, worker's compensation insurance contracts, employer's group plans, or accident and health insurance contracts.
Breaking It Down
Although the passing of a loved one cannot be planned or foreseen, it is still equally important to work with an experienced tax and estate planner to avoid the IRS collecting where they needn't. This article should, therefore, be used more like a checklist to make sure your life insurance policy is in the right place, rather than a "how-to" piece. It is perfectly acceptable to double-check with your estate planner to ensure your insurance payouts will go to the right place.
Taxes Paid on Excess Interest
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. For example, if the death benefit face value is $250,000, 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.
In contrast to life insurance, the amount of taxes a beneficiary might owe on an inherited annuity can depend upon the structure of the annuity contract and whether the beneficiary is a surviving spouse. Also, if the inherited annuity was part of the decedent's defined contribution plan—such as a 401(k)—then rules from the Setting Every Community Up for Retirement Enhancement (SECURE) Act may apply regarding when the beneficiary may take distributions and the amount of taxes owed. Because rules regarding annuities can be complex, it's important you consult with a qualified tax expert regarding your tax obligations.
Complications with Ownership and Estate Planning
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.
Steve Kobrin, LUTCF
The firm of Steven H. Kobrin, LUTCF, Fair Lawn, NJ
Life insurance offers desirable tax advantages, though it is not exactly tax-free. Here are ways your life insurance benefits could be taxed:
- Withdrawing too much from a universal life policy.
- Terminating a cash value policy with outstanding loans.
- Receiving dividends greater than your total premiums.
- Choosing the “accumulate dividends at interest” option.
- Overfunding your life insurance.
- Selecting a payment schedule as the death benefit settlement.
- Putting life insurance inside of a qualified retirement plan.
- Using a split-dollar arrangement to buy life insurance.
- Collecting on a policy kept on a former employee.
- Retaining an incidence of ownership in a policy when you have a large estate.
- Assigning only part of your policy over to your favorite charity as a gift.
- Transferring your policy for value.
The Bottom Line
Although by default a life insurance policy will not be taxed to the beneficiary, it is vital to double-check with your financial planner that your investments are in the right place. Avoiding the above pitfalls can save tens-of-thousands of dollars in unnecessary taxes.