When Is Life Insurance Taxable to Beneficiaries?

When people purchase life insurance policies, they designate a beneficiary who will benefit from the proceeds. When the life insurance policyholder dies, the beneficiary receives a payout known as the death benefit. Life insurance typically is not taxable. However, there are pitfalls to avoid.

Yahoo Finance’s recent article entitled “Will My Beneficiaries Pay Taxes on Life Insurance?” says the significant advantage of buying a life insurance policy is that, upon death, your beneficiaries can get a substantial lump sum payment without taxation, unless the amount of the life insurance pushes your estate above the applicable federal estate tax exemption. In that case, your estate will need to pay the tax.

While death benefits are usually tax-free, there are a few 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. Therefore, if the beneficiary decides to delay the payout instead of receiving it right away, the death benefit may continue to accumulate interest. The death benefit won’t be taxed. However, the beneficiary will typically pay taxes on the additional interest.

If a life insurance policyholder decides to name their estate as the death benefit beneficiary, the estate could be subject to taxation. When you don’t designate a person as your beneficiary, the proceeds from the life insurance policy are subject to Section 2024 of the IRS code. That says, 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).

The proceeds of a life insurance policy may also pass to the estate if the beneficiary dies and there are no contingent beneficiaries. If you have a will in place, the proceeds will be paid out according to the terms of the will. If there’s no will, the probate court decides how to distribute your assets.

The individual insured on a life insurance policy and the policyholder is usually the same person. The policyholder then names a beneficiary. However, a gift tax may apply if the insured, the policyholder, and the beneficiary are three different parties. Because the IRS assumes the death benefit was a gift from the policyholder to the beneficiary, you might have to pay gift taxes on the death benefit.

Beneficiaries usually won’t have to pay taxes on life insurance proceeds. However, some situations can result in a taxable event. Ensure your beneficiary designations are clearly outlined in the policy to avoid taxation.

Reference: Yahoo Finance (Jan. 17, 2023) “Will My Beneficiaries Pay Taxes on Life Insurance?”