Most people know how life insurance works generally, but questions start arising when you get deep into the details.
When a beneficiary receives a life insurance payout, do they owe taxes?
Some life insurance policies are quite large, so paying income taxes on the proceeds of a policy could result in a large tax bill.
Thankfully, you usually do not have to worry about paying taxes on life insurance proceeds as long as the beneficiary is a natural person. However, there are a few special cases where a tax bill might be due.
Here is everything that you need to know about life insurance and taxes, including when you might have to pay them and how to avoid them.
Is Life Insurance Taxable?
One of the biggest questions regarding life insurance is, “Do I have to file taxes on it?” You can rest easy knowing that life insurance payouts are usually not taxable. Suppose you have a large life insurance policy. In that case, your beneficiaries will probably not have to worry about paying income taxes on the policy proceeds they receive from the insurance company after your death.
The IRS exempts the death benefit that beneficiaries receive from a life insurance policy. In fact, most of the time, you never even have to report to the IRS that you received money from a life insurance policy.
This can be a big benefit to people receiving life insurance proceeds. Generally, this money is used to help pay for funeral expenses and other financial burdens caused by a loved one’s death.
Being required to pay taxes on this money would add to the financial burden. Though the general rule is that no taxes will be due, there are a few special cases when the Internal Revenue Service might come knocking.
The following section will detail a few times when you might be required to pay taxes on a policy.
KEY TAKEAWAYS
- Life insurance payouts are generally tax-free, assuming you have established the proper beneficiaries and none of the taxable activities apply.
- If you transfer ownership of a policy, you must adhere to the three-year rule, or you could be subject to taxes post-transfer.
- You can avoid taxes on payouts by naming the proper beneficiaries, establishing an irrevocable life insurance trust, or properly performing an ownership transfer.
When Life Insurance Payouts May Be Taxable
Though the general rule is that life insurance payouts are not taxable income, there are a few exceptions. We will discuss those here. If any of the following situations apply, then you might have a tax bill coming due.
Must read articles related to Wills & Trusts
- Overview of how life insurance works.
- Learn more about what a trust is.
- Deep dive into understanding irrevocable trusts.
- Discover what death tax is.
- Understand what inheritance tax is and tips to avoid it.
3 Ways To Avoid Taxes On Payouts
So, you have heard about a few situations that might cause taxes to be paid on the money received from an insurer. So, how can you avoid these situations and keep your tax liability at zero?
Here are three ways to avoid paying taxes:
Name The Proper Beneficiary
The easiest thing that you can do to avoid taxes is to name a proper beneficiary. Make sure you choose a person as the beneficiary of your life insurance.
That person can receive the proceeds as a lump sum and not owe a single penny of taxes even if the payout is large.
You should also name a contingent beneficiary in case your original beneficiary dies before you. This ensures that your beneficiary is a natural person and thus will qualify for the life insurance tax exemption.
Set Up An Irrevocable Life Insurance Trust
Some people use their life insurance death benefit to fund an irrevocable life insurance trust.
In a way, this lets the life insurance proceeds become part of your estate without the negative tax consequences.
Technically, the proceeds do not become part of your estate. They are owned by the trust itself. Upon the insured’s death, the proceeds enter the trust, and the trust agreement governs how that money is invested and distributed.
This is often used as a form of estate planning. It allows the insured to set the rules for how the trust beneficiaries can access the money. Still, it avoids the pesky tax consequences of leaving money directly to the estate.
Perform An Ownership Transfer
You may need to transfer ownership of your life insurance policy to avoid the proceeds becoming part of your estate.
Whether or not taxes are due can depend on the policy owner at the time of the death of the insured. Just be careful when transferring, as the IRS has precise rules regarding ownership transfers.
The transfer might be subject to gift tax, which is due when you file your tax return.
TIP
You should avoid having life insurance proceeds go into your estate. Depending on the size of your insurance policy, this could lead to a large estate tax.
Policy Ownership Regulations
The three-year rule is one of the most significant regulations regarding establishing policy ownership.
- If a policy is transferred within three years of death, it still becomes part of the taxable estate.
- The original owner must surrender all rights to cancel or surrender the policy, change beneficiaries, or make any other changes to it.
In addition, the original owner must not continue to make premium payments. If the original owner continues to do any of these things, the IRS will likely find that an ownership transfer never really occurred, and the tax advantages of the transfer will be lost.
You should talk to your financial advisor about these rules but know they apply to almost all policy types.
These same transfer rules apply whether you are working with a term life insurance policy, whole life insurance policy, permanent life insurance policy, cash value life insurance policy, or other type of life insurance coverage.
You will want to follow the rules to the letter to avoid federal estate taxes on your life insurance proceeds, especially since the death benefit on some policies can add quite a sizeable taxable amount to the gross income on your tax return.
The Bottom Line
If set up correctly, a life insurance policy can provide significant financial benefits to beneficiaries without worrying about taxes.
Generally, the policy proceeds will not be taxable when received by the beneficiary. However, a few situations can trigger tax consequences.
Ensure you properly plan for those situations and avoid them when possible. Follow the tips outlined in this article to reduce your chances of needing to pay taxes on any life insurance proceeds that you might receive.
Frequently Asked Questions
Generally, you will not owe any taxes from life insurance payouts you receive as a beneficiary.
One significant exception is when you receive interest in addition to the regular proceeds. Interest income is hardly ever tax deductible, so you must pay taxes on the interest.
This usually happens when the policy is payable at some future date, and interest can accrue in the interim.
For example, if you receive $100,000 in proceeds with 10% interest, you may receive $110,000 in total. While no taxes would be due on the base amount of the policy of $100,000, you would owe taxes on the $10,000 worth of interest you received.
Many people often ask, “Are life insurance proceeds taxable?” Life insurance payouts are generally exempt from the IRS.
In most cases, you are not even required to report payouts to the IRS on your tax return.
So, is life insurance tax deductible? Not really. Just because the proceeds are not taxed does not mean they are tax deductible.
Make sure that you consult with your tax professional. In some instances, taxes might be due on a life insurance policy, especially if you are paid interest on a policy or the policy becomes part of an estate.
Proper planning can help avoid these situations and reduce your tax bill.
It depends. If the policy names a contingent beneficiary, the proceeds will go to that beneficiary.
This is why it is imperative to plan for this situation and name a contingent beneficiary in addition to your primary beneficiary.
If there is no contingent beneficiary, the proceeds will likely go to your estate to be distributed according to your will or the intestate succession laws of your state.
Unfortunately, if the proceeds go to your estate, you might be left with a hefty tax bill. They might no longer pass to a beneficiary tax-free, so this situation might cost you thousands of dollars.
One of the biggest requirements is to name a real person as the beneficiary. If the proceeds pass to a real person per the terms of the contract, then they are generally exempt from taxes.
However, allowing the proceeds to go into your estate can have big tax consequences.
If you surrender a policy for the cash value, then that transaction might be taxable. It depends on the surrender value and how much you have paid into the policy in the form of premiums.
Your tax advisor can help you determine exactly how much you will owe in this situation.
You can find a Social Security Administration office near you by using our SSA office locator and searching for your closest location.
