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.
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?
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.
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.
Currently, seven states require an inheritance tax. That said, spouses and other heirs are typically exempt from inheritance taxes.
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.
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.
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.
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.
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.
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.
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.
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.
Check the Alternate Valuation Date
Generally, the value of a property in a deceased’s estate is based on the fair market value on the date of their death. However, the estate executor can opt to use the alternate valuation date to help beneficiaries receive a larger inheritance. This is six months after the decedent passed away.
If the estate is subject to estate tax, consider the alternate valuation. That said, not all estates qualify. You can only use it if it decreases the estate’s gross amount and tax liability.
Set Up an Irrevocable Life Insurance Trust
Irrevocable trusts can protect estates from taxes. As the name suggests, an irrevocable trust can no longer be changed once it’s set up. All assets put in the trust will be owned by the trust. Thus, decreasing the tax liability of the estate.
An irrevocable life insurance trust (ILIT) works the same way. Instead of properties, the trust owns a life insurance policy. The person who set up the ILIT can specify how they want beneficiaries to receive and/or use the insurance proceeds.
Another way of reducing tax liability is to give your beneficiaries or heirs parts of your estate. You can even avoid gift taxes if you don’t exceed the threshold. You can do this annually to slowly transfer your assets to your beneficiaries without paying huge taxes.
Make Charitable Donations
Donations made to IRS-approved charities are not taxable. This allows you to reduce your assets and avoid paying taxes on your inheritance. At the same time, you get to help people in need.
Establish a Family Limited Partnership
Having a family limited partnership is necessary to hold investments, money, stocks, bonds and assets that are being used to run the business. Therefore, helping you transfer assets to your heirs without being subjected to taxes.
Expert Insight on Managing Taxes on Life Insurance Proceeds
Depending on the situation, life insurance proceeds may or may not be taxable. MoneyGeek asked some industry experts to provide insight to help beneficiaries understand how life insurance proceeds get taxed.
- There are various strategies to protect an inheritance from taxes. What is the best option to minimize the risk of being taxed on life insurance payouts?
- What’s the best type of life insurance for estate planning? Why?
- What tips can you share with individuals creating an estate plan that includes life insurance?
- What tips or advice can you give beneficiaries to help them maximize life insurance payouts or death benefits?
Estate Settlement Officer at Greenleaf Trust
Founder and Principal Advisor at Progressive Wealth Management
Assistant Professor of Accounting at Arkansas State University
CPA, CFP®, MSTFP, Instructor at Widener University
Senior Tax Manager at Truepoint Wealth Counsel
Associate Professor of Accounting at Bucknell University
Founder & CEO of Seniors Life Insurance Finder
Resources for Managing Taxes as Beneficiaries
Managing taxes on life insurance proceeds can be challenging for beneficiaries. Access to resources can help you better understand life insurance, taxation and estate planning.
- Better Business Bureau: Use the search tool to find information about a specific life insurance company. Check insurance providers’ trustworthiness ratings.
- Coalition Against Insurance Fraud: Find links to state insurance fraud bureaus and learn how to report suspected insurance fraud.
- Insurance Information Institute: Access different life insurance guides. Get tips to find the right life insurance policy.
- National Association of Insurance Commissioners (NAIC): Select your state using NAIC’s dropdown menu to find the contact information of your state’s insurance department to learn about local insurance laws.
- USA.gov: Learn about different federal laws and regulations, including insurance and taxation.
Taxes and Laws
- 1-800-ATTORNEY: Contact this national network and get free legal advice on taxes, life insurance and estate planning.
- American Bar Association: Learn about estate planning, state laws, the various estate planning tools you can use and how you can better manage your estate.
- American College of Trust and Estate Counsel: Access an updated state death tax chart and learn about the types of taxes imposed in each state.
- Cornell Law School – Legal Information Institute: Read the Life Insurance Act and learn about how life insurance products are taxed.
- IRS Tax Forms: Download IRS forms and read about the different types of taxes.
- Tax Foundation: Check current income tax rates to see how much your tax liability is.
About Nathan Paulus
- AARP. "17 States with Estate or Inheritance Taxes." Accessed November 17, 2022.
- Federal Reserve. "Changes in U.S. Family Finances from 2016 to 2019: Evidence from the Survey of Consumer Finances." Accessed November 16, 2022.
- Internal Revenue Service. "Estate Tax." Accessed November 17, 2022.
- Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2023." Accessed December 19, 2022.
- Internal Revenue Service. "Life Insurance and Disability Insurance Proceeds." Accessed November 19, 2022.
- Internal Revenue Service. "Survivors, Executors and Administrators." Accessed November 16, 2022.
- LIMRA. "2020 Insurance Barometer Study." Accessed November 16, 2022.