How to Avoid Taxes on Life Insurance Proceeds

The average funeral cost in 2021 was $7,848 for a wake and burial or $6,971 for cremation. The average cost of settling an estate varies, but a complicated estate could push $5,000 with ease. And none of this is accounting for the time put into planning, prepping and selling assets (like a home) to settle affairs.

The point is that death — just like life — is expensive. Life insurance is the a common way to pay for these expenses, but many forget about one thing — Uncle Sam’s cut of the proceeds. If you stand to be a beneficiary of a life insurance policy there’s some tax implications you need to know.

For assistance with your own estate planning and life insurance selection, consider working with a local financial advisor.

How Is Life Insurance Taxed?

Life insurance is not taxed directly because the IRS doesn’t require you to report it as income, meaning you will pay no income taxes as a beneficiary of a life insurance policy. However, there are several “backdoors” where taxes can be implemented and eat into those proceeds.

Let’s look at how the government is using alternative routes to tax life insurance so you can better understand how to avoid taxation all around.

The Gift Tax

The gift tax is normally reserved for the donor who is doing the gifting, but in the case of life insurance, the gift tax can be implemented if you have a special three-person involvement. Typically you only have two people involved in life insurance, the one who buys the policy and insures himself and the beneficiary who receives the payout. In this case, the gift tax doesn’t apply. But if there are three people filling the three roles separately (listed below) it can apply.

The policy owner: Purchases the policy
The insured: Has his life his covered in the policy
The beneficiary: Receivez the benefit when the insured passes

Avoiding The Gift Tax

Getting around the gift tax as a life insurance beneficiary is typically not an issue for the average person. The gift tax only applies after the insured passes and if their estate worth exceeds $12.06 million.

If you do fall into this category then expect a tax on the life insurance proceeds of approximately 18% to 40%. Otherwise, your only responsibility is to report the gift on IRS Form 709 when you file that year’s tax return.

Estate Absorption

If you are the beneficiary of a life insurance policy from a person who has an estate over the estate tax exemption limit ($12.06 million) you could have to pay estate taxes for that payout. Whenever an insurer has an estate that is pushed over the tax exemption limit by life insurance proceeds, those proceeds are absorbed into the estate value and any value that’s over the limit will be taxed as estate taxes that are owed by the heir(s) of the estate.

Avoiding The Estate Tax

To avoid this loophole, the estate owner would need to have either a will or trust in place and leave you as the beneficiary. Then other assets would be liquidated to cover the costs of the estate taxes and you would receive the full life insurance proceeds tax-free.

Otherwise, you’re looking at a hefty federal estate tax between 18% and 40% depending on how large the proceed payout was and how much it pushed the estate over the tax exemption limit. Since this can be a tricky avenue to go down, hiring a professional is highly suggested.

Death Benefit Installments

Opting to take installments on a life insurance payout versus a lump sum is popular but can cost you. A lump sum life insurance payout is a tax-free event, but taking payments in installments is known as an annuity. This will create an interest-bearing account for the lump sum. The interest accrued on that sum is what becomes taxable.

Avoiding Taxes on Interest From Installments

The most obvious way to avoid this tax is to simply take the lump sum. But keep in mind that if you are planning on investing the payout you’re already a step ahead of the curve. Normal investments are taxed when you earn the money you’re investing and taxed again when you earn any gains from the investment.

By investing a lump sum of money like a life insurance payout, you are basically skipping the first round of taxes.

The Bottom Line

Most instances where you receive life insurance proceeds are tax-exempt. The responsibility for tax implications will typically only fall on the insurer or the policyholder. Plus the vast majority of these tax situations can be easily avoided if you spot them early enough.

Tips for Estate Planning

Consider talking to your financial advisor about how life insurance can help with estate planning and whether it makes sense for you. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
In addition to life insurance, there are other elements you may want to include in your estate plan. A last will and testament, for instance, is a fundamental part of estate planning for ensuring that your assets are distributed according to your wishes. You can also use a will to name a guardian for minor children.