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.
What Is a Death Benefit?
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.
When Is Life Insurance Taxable?
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 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.
Estate and Inheritance Taxes
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, with a 40% tax rate cap.
No Contingent Beneficiaries Named
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, 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.
Three Individuals Are Named on the Policy
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, in 2023, the annual exclusion is $17,000.
How to Avoid Taxes on Life Insurance Benefits?
To help your beneficiaries avoid taxation on death benefits, here are three common steps you can take:
- Inform your beneficiaries of the life insurance policy. It may seem counterintuitive, but plenty of life insurance proceeds go unclaimed. Benefits usually go unclaimed because beneficiaries were not aware of the policy. So, once you take out a life insurance policy, be sure to provide your beneficiaries with all the applicable information. Some information you should share includes the insurance company’s name and how to file a claim after your death.
- Name a primary beneficiary and a contingent beneficiary. The proceeds of a life insurance policy with an unnamed beneficiary transfer to the owner’s estate, which can cause a taxable event. So, to avoid this situation, name a primary beneficiary and at least one contingent beneficiary. It’s also wise to regularly review and update your beneficiaries to ensure the death benefit goes to the right person. For example, if you just got married, you may want to update your beneficiary to your spouse.
- Share the benefits of a lump sum distribution. Upon your death, a beneficiary can decide how they want to receive the death benefit. The beneficiary can choose either a lump sum payment, interest payments, or another option. Choosing a lump sum payment will help the beneficiary avoid taxation on interest. Plus, they can immediately use the funds for their most significant financial needs, whether their mortgage or to pay off another form of debt.
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.
Tips for Planning Your Estate
- When planning your estate, it’s wise to work with a financial advisor who can guide you and offer advice. SmartAsset’s free tool matches you with up to three vetted 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.
- Probate is often cumbersome, time-consuming, and expensive, especially after losing a loved one. After you pass away, your successor trustee can distribute your trust assets directly to your beneficiaries.
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