Generally speaking, the proceeds of a life insurance policy are not counted as taxable income, and the beneficiary does not have to pay taxes on them. However, there are some exceptions. If the policyholder elects not to have the benefit paid out immediately upon their death or, if the death benefit is paid to an estate, the heir may have to pay estate taxes.
If interest accumulates before the benefit is paid out, the beneficiary must pay taxes on the interest. For example, If a $1 Million death benefit earns interest at 10% for one year before being paid out, the beneficiary will owe taxes on the $100,000 of accumulated interest.
If you are preparing to purchase life insurance and need more information about various coverages, contact our knowledgeable agents here at YourPolicy. They understand death benefits and can explain your options. To understand any tax implications associated with life insurance proceeds, you should consult an inheritance attorney or tax professional.
When Are Life Insurance Proceeds Taxable?
If you receive a life insurance payout as a beneficiary, you may have to pay taxes on that inheritance. To determine whether taxes are due, you will need to look at three factors:
- 1) who owns the policy,
- 2) the reason for death, and
- 3) the reason for receiving the insurance payout.
Ownership: Taxes will be due on insurance proceeds if the person who passed away contributed significantly to the cost of the policy.
Reason for Death: If death was due to an accident or illness, taxes are generally not owed on the insurance payout. However, if the policyholder committed suicide, taxes are likely due, unless the policy is an accidental death policy.
Reason for Receiving the Insurance Payout: If you are the beneficiary of a life insurance policy that was purchased with after-tax dollars, taxes are not owed on the insurance proceeds. However, if the beneficiary is an estate or trust and the policy was purchased with pre-tax dollars, taxes are due on the insurance proceeds.
Estate and Inheritance Taxes
If a life insurance policy is named “payable to my estate,” the proceeds are subject to the probate process. Leaving items to your estate also increases the estate’s value and could subject the heirs to excessively high estate taxes.
Workarounds to Avoid Taxes
If you want to avoid federal taxation on life insurance proceeds, ownership of your policy can be transferred to another person or entity.
According to Investopedia, here are a few guidelines to remember when considering ownership transfer:
- Choose a competent adult/entity to be the new owner (it may be the policy beneficiary), then call your insurance company for the proper assignment, or transfer of ownership forms.
- New owners must pay the premiums on the policy. However, you can gift up to $16,000 in 2022, so the recipient could use some of this gift to pay premiums.
- You will give up all rights to make changes to this policy in the future. However, if a child, family member, or friend is named the new owner, changes can be made by the new owner at your request.
- Because ownership transfer is an irrevocable event, be careful of divorce situations when planning to name the new owner.
- Obtain written confirmation from your insurance company as proof of the ownership change.
Life Insurance Trust
Another way to avoid taxes is with an irrevocable life insurance trust (ILIT). In this instance, the policy is held in trust and you are no longer the owner. The proceeds are no longer included as part of your estate. Even though you are no longer the owner, you still have some legal control over the policy and can ensure that the new owner is paying all premiums promptly. If the beneficiaries are minor children from a previous marriage an ILIT will allow you to name a trusted family member as trustee. This person can oversee the money for the minor children.
Inheritance and estate taxes can be complicated, and the above information provides an overview of how certain situations can affect your tax obligations. As always, please consult tax and legal experts to help you navigate these circumstances.