Managing Federal Taxes on Life Insurance Proceeds

Name: Managing Federal Taxes on Life Insurance Proceeds
Item: Managing Federal Taxes on Life Insurance Proceeds
Author: Nathan Paulus

Contributions by 6+ experts

Updated: July 3, 2024

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Dealing with a loved one’s death is overwhelming. Aside from the emotional turmoil, there are various things to take care of, such as arranging funeral services, handling estate and personal property matters and settling debts. That’s why receiving death benefits from your loved one’s life insurance policy helps reduce financial burdens and stress.

Being a life insurance beneficiary can also be challenging. There are complex financial matters to navigate, such as the taxation on the life insurance proceeds. By understanding the tax types you may encounter, when proceeds are taxable and the different strategies to reduce tax liability, you can maximize life insurance payouts and avoid making mistakes.

Generally, beneficiaries don’t have to report the life insurance proceeds they receive in their gross taxable income. However, if the beneficiary receives interest on life insurance proceeds, they must pay taxes. Life insurance payouts that go into taxable estates are also taxable when they exceed a specific dollar amount.

Life insurance is typically for the financial protection of the policyholder’s chosen beneficiaries, but many also use it for estate planning. More than 55% say their goal is income replacement and wealth transfer across generations. Meanwhile, 80% say they purchased life insurance for burial costs and final expenses.

If your life insurance proceeds are subject to taxes, choosing a lump sum payout and learning more about taxes that apply to life insurance could help you reduce your tax liability. Working with a professional can make it easier to evaluate your options and choose the best course of action for you and your family.

If you plan to pass an inheritance to your family, there are also numerous strategies you can employ to help your loved ones make the most out of your money; these include setting an alternate valuation date, setting up an irrevocable life insurance trust, giving gifts, making charitable donations or establishing a family limited partnership.

Sources:

Federal Reserve, Internal Revenue Service

Is a Life Insurance Payout Taxable?

Generally, life insurance payouts aren’t taxable. Beneficiaries don’t have to report them as income whether they receive the payout in a lump sum or as annual dividends.

That said, life insurance proceeds may be taxed in some cases. For instance, the interest is taxable if you receive it on a life insurance death benefit. There will also be tax liabilities if the payout goes into a taxable estate or if three or more people are involved.

How Is Life Insurance Taxed?

Generally, the purpose of life insurance is to provide financial protection. Depending on how a policy is set up, it can be used for burial or funeral expenses, as income replacement, as supplemental retirement income or even for paying off a mortgage. Many also use life insurance for estate planning.

In most cases, payouts and death benefits are tax-free. However, estate tax may be applicable if the named beneficiary is an estate. If the beneficiary only receives interest on the death benefit, they’ll have to pay income tax on the interest. There may also be inheritance taxes depending on the state.

Tax Types You Need to Know

Depending on how you receive the death benefits or how the policyholder sets up their life insurance, you may have to pay taxes.

Type of Tax	How Does It Tax You?
Income tax	This refers to the tax liability of an individual, a married couple or a business based on the money they’ve earned throughout the year. The amount is based on the net income tax rate. Life insurance proceeds are typically income-tax-free. However, if the beneficiary receives payouts in installments and only gets the interest on the death benefit, they’ll have to pay income tax.
Estate tax	A policyholder may decide to assign an estate as their beneficiary. In such cases, the estate involved may have to pay tax on the entire estate’s value. The federal estate tax is computed based on the estate’s total value, including assets, property, cash and investments. Some states also have an estate tax. Estate taxes are typically paid before heirs receive any of the deceased's possessions.
Inheritance tax	Currently, seven states require an inheritance tax. That said, spouses and other heirs are typically exempt from inheritance taxes.
Generation-skipping tax	If an inheritance isn’t given to the immediate descendant but to another person, a generation-skipping tax may apply. For example, a grandparent may leave property to their grandchildren instead of their children. It may also apply to other family members or unrelated individuals at least 37 ½ years younger than the deceased.

An illustrative image of when life insurance is taxable.

When Are Life Insurance Proceeds Taxable?

Life insurance death benefits can sometimes be taxable. Understanding how the policy is set up can help you know what tax types to expect. The payout option can also determine whether there’s a tax liability. Make sure you check these pieces of information with the insurance provider before filing a claim.

You’re receiving interest on a death benefit

Death benefits from life insurance aren’t considered income, so beneficiaries usually don’t have to report them when they file their income tax. However, the situation may change depending on the payout option.

If the payout is in installments and you only receive the interest, the death benefit accumulates, and you’ll be subject to income tax for the said interest. If you choose the payout option, consider getting the proceeds in a lump sum to avoid getting taxed.

The payout goes into a taxable estate

If the policyholder names their estate as the beneficiary of their life insurance policy’s proceeds, estate taxes may apply based on the size of the estate. If the deceased failed to name beneficiaries on their policy, the death benefits would be considered part of their estate.

The policy involves three different people

There are three roles in a policy — the owner, insured and beneficiary. Typically, a person buying life insurance plays the role of owner and insured. But there are cases when a different person holds each role. This may result in taxation.

For example, John purchased a life insurance policy for his daughter Jane and named his granddaughter Jenny as the beneficiary. John is considered the owner of the policy, while Jane is the insured person.

If Jane passes away, the death benefits will go to Jenny. Since John is the owner, the policy is considered a gift from him to Jenny. He’d have to pay gift taxes exceeding the $17,000 annual and $12,920,000 basic exclusion.

But, generally, the life insurance benefits aren’t federally taxed as long as Jenny remains the beneficiary. The most common reason the proceeds would be taxable is if the beneficiary sells the policy to a third party. Since the third party isn’t the beneficiary, they’d have to pay taxes on the difference between the amount they paid for the policy and the amount they received from the insurance provider.

The amount of estate exceeds the estate tax threshold

If the death benefits go to the policyholder’s estate and exceed the threshold, it’ll be subject to estate tax. The threshold is $12,060,000 for 2022 and $12,920,000 for 2023. States may also impose estate taxes.

An illustrative image of when life insurance is not taxable.

When Are Life Insurance Proceeds Not Taxable?

Except for rare instances, life insurance payouts and death benefits are often not taxable. Some situations when you don’t have to worry about taxes include getting the payout in a lump sum, making a partial withdrawal from the cash value and receiving annual dividends.

You get a payout directly in a lump sum

If the beneficiary receives the death benefit in a lump sum, they don’t have to worry about taxation, no matter the amount. Some policy owners decide how the payout will be made. The beneficiary may decide on the payment option if there’s no specified method.

You’re making a partial withdrawal from a permanent insurance’s cash value

If the policy has a cash value and the insured decides to make a partial withdrawal, that money isn’t taxable. However, if the insured fails to pay back the amount they borrowed before their death, it’ll be subtracted from the policy’s death benefit. Additionally, the increase is taxable if the insured cancels their permanent life insurance policy and receives a cash payout value above the premiums paid over its entire term.

You’re receiving annual dividends

If the life insurance policy is from a mutual insurance company, the policyholder receives annual dividends from the insurer. That’s because they’re considered mutual or shared owners of the company. These payouts are not taxable. However, if the amount exceeds the premiums paid, the payout becomes taxable.

An illustrative image of ways to reduce tax liability.

Beneficiaries: Strategies to Reduce Tax Liability

If you’re a beneficiary of a life insurance policy, the first thing you need to do is determine if the proceeds will be subject to taxes. You can check the payment option and how the policyholder sets up their insurance. Discuss with the insurance provider the process you need to accomplish and the decisions you have to make. Consulting a professional can also help you better understand taxation and find ways to reduce your tax liability.

Choose a Lump Sum Payout

Ask the insurance provider if the policyholder has specified how the proceeds will be paid out. If they didn’t, consider choosing a lump sum payout. This will give you immediate access to the total death benefit amount. You can use it to cover funeral and burial costs or keep it for future use. That said, getting the proceeds at once may be disadvantageous if the beneficiary’s financial planning isn’t great, as they may spend too much.

LEARN THE PROCESS

Typically, insurance providers don’t track down life insurance beneficiaries. You’ll have to file a claim to get the proceeds. Contact the insurance provider and ask them about the claims process. Gather all necessary documents and submit them with a completed claims form. The insurer will then evaluate the validity of your claim.

If you’re unsure whether you were named as a beneficiary, try to look for a copy of your loved one’s life insurance policy. You may also use the NAIC Life Policy Locator.

Understand and Determine Tax Characteristics

Understanding the different types of taxes related to life insurance death benefits and when they’re applicable can help you prepare for possible taxation. This will also help you explore ways to reduce your tax liability.

Visiting the Internal Revenue Service’s (IRS) website can help you understand the different types of taxes. You can also use the IRS’ interactive tool to determine if the life insurance proceeds you have received are taxable.

CHECK STATE LAWS

Depending on where you live, you may also be subject to state taxes. Check your state laws on life insurance proceeds. You can visit your state’s official website. An online search can also help you find helpful information.

Get Help from Professionals

Navigating taxes and your finances can be challenging. Getting help from the right people can help you avoid making mistakes that could cost you.

For instance, a tax advisor can help you understand your tax liabilities. They can assist you in preparing your tax returns and ensure you’re paying the right amount. Additionally, they can determine if there are additional ways to reduce your tax liabilities.

As a beneficiary, you may get a huge amount from your loved one’s death benefits. Hiring a financial advisor can help you better manage your finances to achieve your financial goals.

How to Find the Right Advisor

If you’re planning to hire a professional, finding the right one is essential. Consider your needs and determine what type of advisor you’ll need. Then, start your search. You can do this by conducting an online search for advisors serving in your area.

Check their qualifications.
Ask about their experience.
Read reviews, if possible.
Ask about their fees.
Check your compatibility with the advisor.

Making the Most of Death Benefits

Receiving life insurance proceeds can help you with your finances. You can choose how to spend the death benefits from a loved one’s life insurance policy as a beneficiary. However, you need to be smart about your spending to maximize the life insurance payouts. Fortunately, there are multiple ways to do this.

Don’t rush big financial decisions

You don’t have to decide what to do with the money immediately after receiving it. If possible, experts recommend waiting at least six months before making big financial decisions, including large purchases or spending death benefits.

Pay off high-interest debt

Evaluate your debts. If you have high-interest debt or loans, pay them off first. This will stop you from accumulating more debt. At the same time, it reduces the expenses you have to worry about every month.

Hire a trusted financial advisor

If you don’t know anyone with the right experience and credentials to help you manage your finances, hire a financial advisor. Choose one who has experience handling life insurance death benefits or has helped people in similar situations.

Keep the money to pay bills

Prioritize essential expenses, such as utility bills, school fees and food. If the deceased is your family’s primary income earner, you may need to spend some of the life insurance proceeds on household needs. You can set aside a portion of the money to manage expenses for the first few months while you’re searching for a source of income.

Build an emergency fund

It’s best to keep a portion of the death benefit and place it in a high-yield savings account. This way, you’ll have money to cover possible financial emergencies.

Invest

Another way for beneficiaries to grow their money is to invest some life insurance benefits. If you’re new at investing, it’s best to consult a financial professional. Ask them for advice on choosing the right portfolio, including diversification of the investments, such as how much should be invested, for how long, and how much cash should be withheld.

MONEYGEEK EXPERT TIP

Except for paying bills and paying off debt, it is usually wise to wait at least six months to make any big decisions about using life insurance proceeds (i.e., buying a second home, boat, etc.).

Ways to Protect Your Inheritance From Tax Burdens

Estate planning is the process of preparing for the distribution of one’s assets. It helps ensure that a person’s wishes — who’ll receive certain assets and how their affairs will be handled — are followed. Life insurance can be used to complement other estate planning tools like wills and trusts for better estate equalization.