When beneficiaries receive a payout from a life insurance policy, they typically don’t have to pay taxes. However, there are a few situations where a portion of the life insurance benefit is taxable to the beneficiary. So, whether you have a life insurance policy or are the beneficiary of one, here’s what you need to know about the payout and taxation. A financial advisor can help you figure out how life insurance fits into your financial plan.
When folks take out life insurance policies, they name a beneficiary who will benefit from the policy’s proceeds. As a policyholder, you can name spouses, children, friends, or almost anyone as a beneficiary.
Then, when the life insurance policyholder passes away, the policy’s beneficiary receives a payout known as the death benefit. The death benefit amount depends on the type of policy and the insurer. Beneficiaries could receive anywhere from a few thousand dollars to over $1 million.
The primary advantage of buying a life insurance policy is that upon death, your heirs or beneficiaries can receive a substantial lump sum payment without federal taxation. Although death benefits are usually tax-free, there are a couple of situations where the beneficiary of a life insurance policy may have to pay taxes on the lump sum payout.
When you earn income from interest, it’s typically taxable. In other words, if the beneficiary decides to delay the payout instead of receiving it right away, the death benefit may continue to accumulate interest. So, while the death benefit will not be taxed, the beneficiary will typically pay taxes on the additional interest.
For example, let’s say the lump sum payout was $100,000, and the beneficiary was selected to wait two years before taking the death benefits. During the two years, the death benefit earned 10% interest. Therefore, the beneficiary would owe taxes on the additional $10,000 accumulation.
If a life insurance policyholder decides to name their estate as the death benefit beneficiary, the estate could be subject to taxation. When you forgo naming an individual your beneficiary, the proceeds from the life insurance policy are subject to Section 2024 of the IRS code.
This code states that if the gross estate incorporates proceeds of a life insurance policy, the value of a life insurance policy must be payable to the estate directly or indirectly or to named beneficiaries (if you had any “incidents of ownership” throughout the policy term). Remember, most estates won’t be subject to federal taxation since the exclusion amount is $12.92 million in 2023 ($13.61 million in 2024), with a 40% tax rate cap.
The proceeds of a life insurance policy may also pass to the estate if the beneficiary dies and there are no contingent beneficiaries. In this case, if you have a will in place, the proceeds will be paid out according to the terms of the will. On the other hand, if there is no will in place, the probate court determines how to distribute your assets. Remember, probate is a time-consuming and expensive process that can minimize the size of your estate for your heirs.
Usually, the person insured on a life insurance policy and the policyholder are the same. Then, the policyholder designates a beneficiary. However, a gift tax may apply if the insured, the policyholder, and the beneficiary are three different parties. This situation creates what’s known as the Goodman triangle. Because the IRS assumes that the death benefit was a gift from the policyholder to the beneficiary, you might have to pay gift taxes on the death benefit.
For example, let’s say your spouse buys a life insurance policy for you, naming your adult children the beneficiaries. In this case, three people are named in the policy, your spouse (the owner, you (the insured), and your adult children (the beneficiaries). Therefore, if you pass away, the IRS considers the death benefits a gift from your spouse to you and your children, thus creating a taxable event. Furthermore, you would have to file a gift tax return for your children on the proceeds of the life insurance policy.
Keep in mind, that in 2023, the annual exclusion is $17,000 ($18,000 in 2024).
To help your beneficiaries avoid taxation on death benefits, here are three common steps you can take:
Typically, beneficiaries won’t have to pay taxes on life insurance proceeds. However, some situations can result in a taxable event. Making sure beneficiary designations are clearly outlined in the policy is one of the best ways to avoid taxation. But, because everyone has a unique situation, it’s best to consult with a financial advisor and tax professional. Working with financial professionals can help you understand your and your beneficiary’s tax liability, if any.
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Ashley KilroyAshley Kilroy is an experienced financial writer currently serving as an investment and insurance expert at SmartAsset. In addition to being a contributing writer at SmartAsset, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.
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