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.
- Usually, there are no taxes owed, when a beneficiary of a life insurance policy receives the death benefit; however, there are a few exceptions.
- If the policyholder has arranged for the insurance company to hold the policy for a few months before transferring it to the beneficiary, then the interest earned in that interim period would usually be taxable.
- If the policyholder has made the beneficiary of the policy an estate, rather than an individual, then the person or people inheriting the estate might have to pay estate taxes.
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.
According to the IRS, if the life insurance policy was transferred to you for cash or other assets, the amount that you exclude as gross income when you file taxes is limited to the sum of the consideration you paid, any additional premiums you paid, and certain other amounts—in other words, you can't overpay for a policy as a way to cut your taxable income.
Estate and Inheritance Taxes
In some cases, life insurance proceeds are paid to the estate of the deceased. This 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.
Robert E. Maloney, AEP
Squam Lakes Financial Advisors, LLC, Holderness, NH
A will can include an "apportionment clause” that leads to tax liabilities for the beneficiary. For instance, the clause may state that if there are any estate taxes due, they will be paid proportionally by the beneficiaries who receive the assets from the benefactor. Under this circumstance, 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 pays out the proceeds of the policy to the beneficiary over an extended period of time. The face amount of the policy, however, is received income tax-free. The law also requires the insurance company to pay interest to the beneficiary from the date of death until they pay out the proceeds.