When a policyholder passes away and their beneficiaries receive the rightful benefits, many wonder whether they will be taxed on the significant additional income. Depending on their policy, the insured person may also debate if they need to include these proceeds when they file taxes. In general, taxation laws vary in complex ways defined by detailed conditions.
Because of that, tax needs change from case to case, payment to payment, and situation to situation. This makes it crucial to explore which taxation rules and requirements apply to you. You never want to be surprised by omitting legally necessary income, but you also wouldn’t want to report more income than required to be taxed much more than necessary.
The question becomes difficult to answer without expert guidance. In some situations, beneficiaries can be taxed for every payment from the insurance company. In others, only specific types of payments qualify as income and require taxation. Tax law considers many elements before deciding if you need to be taxed. You will find that some will apply to your situation based on who receives benefits and how they are paid.
To answer another of our most frequently asked questions, here are the most common situations that require and do not require taxes. See if your policy or payment will trigger taxes on death benefits.
Common Kinds of Taxable Life Insurance Death Benefits
While few people are taxed after the death of the policyholder, some do have the responsibility to pay a tax on life insurance death benefits according to the IRS. However, like all income, the law can make death benefits taxable and require a percentage of the profits. Examples situations include:
- Decisions for interest or miscellaneous income
- Beneficiary types and policy structures
- Policies with cash value withdrawals and loans
- Benefits from employer-sponsored insurance
- Ownership, transfer, and control of the policy
Consider how the following situations may apply to you as a death benefit beneficiary. Our insight into taxable life insurance benefits will support your financial decisions before you find the IRS imposing taxes on your income. You’ll also avoid reporting taxable income that they don’t require and save considerably.
Interest and Annuity Payments
Mostly, tax law dictates that interest payments are taxable. Life insurance benefits cannot avoid this rule when beneficiaries decide to hold off on receiving full death benefits to increase their value. Life insurance companies can often keep death benefits so that they can accrue interest. While you won’t need to pay tax on the original amount, any interest accumulated after the policyholder dies will need to be reported as taxable income.
That means that if a policyholder is interested in having a death benefit grow over time as a way to ensure their loved ones get more income than the amount the policy promised, they should consider its true advantage after taxes. Whenever the installments are paid from interest growth, it will contribute to their gross, taxable income.
Understanding this, the insured and their beneficiaries should realize that interest-paying death proceeds make financial sense in some cases and not in others. They should consider whether their dependents, loved ones, or anyone named can afford to delay the full payment and how it will impact them.
Beneficiaries and Estate Taxes
Rarely are beneficiaries taxed on the amount they receive from life insurance death benefits. But, an exception is made for giving the payments to an estate. When someone insured by a life insurance policy chooses to make their benefits payable to their estate worth more than $11.7 million, just as it applies to IRA accounts and annuities. If the estate benefits from their policy proceeds, the advantage of tax-free income to beneficiaries is sacrificed. In effect, it makes the policy’s financial contribution subject to a probated process from estate tax rules defined by the IRS.
Employer-Sponsored Benefits
Some employers offer life insurance and pay its premiums themselves. Often, this takes the form of a group policy, and, when its coverage exceeds $50,000 in coverage for you, it is subject to a tax. More than that, group policies are not the only form of life insurance that employers can support you through. Even a supplemental life insurance policy can be taxed. Though it intends to help you add to existing group coverage, supplemental insurance can push you past the $50,000 limit and bring the IRS a percentage of the benefits your employer and you have paid.
Three-Person Life Insurance Policies
Typically, a life insurance policy is created and paid by the insured person. A father who wants to protect his spouse and children will take out a policy to lessen additional and financial suffering. But, if a third person like a friend or interested party takes out a life insurance policy to help your beneficiaries or themselves, they are responsible for the taxes that apply.
While buying a policy with death benefits on someone else is strictly controlled by many different limitations, the true owner introduces a gift tax. A gift tax by IRS standards is set on any amount transferred to an individual without being returned in full. This rule applies to any gift over $15,000, and it can affect life insurance benefits in other ways as well.
Gift Tax Rates after $15,000 Limit
| Less than or $10,000 | 18% |
| Less than or $20,000 | 20% |
| Less than or $40,000 | 22% |
| Less than or $60,000 | 24% |
| Less than or $80,000 | 26% |
| Less than or $100,000 | 28% |
| $100,001 to $1M | 30% to 39% |
To note, the three-person policy structure that has an owner, an insured, and a beneficiary is as serious as estate taxes because it falls within the scope of that category. Ownership is one of the most important considerations that the IRS makes in determining whether it has a right to death benefit money. Estate tax rates are high, and they apply to both term and whole life insurance policies that take a three-role form. In some cases, the entire amount can be taxed by as much as 50 percent, meaning the people it was designed to help will never see most of its potential impact on their lives.
Non-taxable Life Insurance Benefits
Protecting a full policy of financial protection is important. For that reason, the insured and their beneficiaries need to think about how to retain as much as possible from death benefits. Since every person concerned in a life insurance policy might worry about these rules and risks, here are some situations and strategies that can limit tax responsibilities.
Personal Beneficiaries
For the most part, tax law neglects to tax individuals on death benefits they receive. Although this changes for those who receive installments, gain interest, or are involved in third-party ownership, choosing to avoid giving the proceeds to an estate is a tax-free decision. Policyholders often give directly to their beneficiaries, and that makes it simple to help cut out estate and gift tax responsibilities.
Lump-Sum Death Benefits
As long as the beneficiary is not an estate, the payout will not be taxed regardless of the amount. The income generated will simply not trigger tax categories to deserve a portion of the profits from those the policy aims to protect and support. This is because the IRS has decided that they do not apply as gross income. Full payment upon death allows beneficiaries to avoid the annuity-like tax rules, and it serves the policy owner to avoid payment structures that give partial amounts simply to accrue interest.
Self-owned Policies
Since including a third person in the life insurance policy who owns the policy makes it a gift, the policyholder should be the owner if taxes are to be avoided. Because it is highly regulated and complex to take out life insurance on another person, most do not consider this tax. It can apply to the entire policy payout even when the owner is a spouse looking to benefit children with a family life insurance policy. While the policyholder will never pay such a tax, its percentage will take from beneficiaries.
Give the Fullest Death Benefits to Your Loved Ones
To avoid losing the benefits possible through your careful selection of a life insurance policy, you should ask more than for the lowest premium and highest coverage. No matter how promising a death benefit may look, choosing to structure or buy a policy without considering taxes will cut its value. Discussing your concerns with a tax professional or estate planner is an excellent idea, but the situations above are some of the most common and serious tax situations that cause upset.
Note that gifts, estates, and annuities are categories that the IRS uses most to determine whether a particular payment is taxable. Knowing these definitions and deciding on a policy that doesn’t bring complications to your beneficiaries can be a wonderful way to show your beneficiaries the thoughtfulness and care they’ve enjoyed during your life. It’s especially important because it aligns with the purpose you have in keeping your policy as active and promising as possible.
Unfortunately, some of the situations triggering taxes can be so attractive. For instance, the desire to withhold benefits so they create regular payments and grow in value seems like a wise decision. At the same time, beneficiaries may think that this can also add security to their financial lives. Then, protecting your spouse with a policy you control looks like a loving and protective thing to do for your children. A supplement plan through an insurer can appear not to hurt at all and well worth the investment.
After death, these can prove to reduce your intent to help loved ones and be ways for beneficiaries to lose your last gift. You can structure your death benefits carefully for the greatest profit to your beneficiaries after you find the best premiums and policies with Sproutt.com.
For Sproutt’s expert insight and latest posts to help you navigate life insurance topics, subscribe below.
