The unexpected death of an acquaintance or loved one is never an easy or pleasant experience. Consequently, the life insurance death benefit often gives many beneficiaries much-needed financial security. Unfortunately, trying to work through what happens in the process of settling an estate, one very important question many people find themselves asking is: Are there tax consequences when someone dies, and you are the beneficiary of their insurance?
Fortunately, in most cases, the answer is no, but with some key exceptions. Understanding the IRS life insurance rules helps to avoid unforeseen tax liabilities on what was otherwise designed as a tax-free ‘lifeline.’
The Golden Rule: The Death Benefit is Generally Income Tax-Free
For most beneficiaries in the United States, the good news is deceptively straightforward: If you have a standard life insurance policy, the lump sum payout is not generally considered taxable income.
This means that if you are the named beneficiary on a $500,000 policy, you typically receive the entire $500,000 without having to report it as gross income on your annual tax return. This fundamental exclusion applies to both term life and the death benefit portion of permanent policies (like whole or universal life).
While the death benefit is tax-free in and of itself, a few instances will indeed impose taxes on money associated with it. These fall under three main categories: interest, estate taxes, and ownership structure.
- The Taxable Exception: Interest on the Payout
This is the most common way a beneficiary can incur a tax liability on a life insurance payout.
If the death benefit is not paid out immediately and remains with the insurance company for any period, then the insurance company will credit interest on that amount. This normally takes one of two forms:
Delayed Payment: Used if the claim process takes time or the beneficiary chooses to leave the death benefit proceeds with the insurer in an account, such as a settlement option, rather than taking a lump-sum payment.
Installment Payments: If the beneficiary elects to take the death benefit in scheduled payments other than a lump sum, such as annually or monthly, each installment will consist of one part of the original principal money that is tax-free-and another part of interest money that is taxable.
The Rule: The original life insurance death benefits principal remains tax-free, but any interest accrued on that money is taxable income to the beneficiary. The beneficiary will usually receive a Form 1099-INT reporting this taxable interest income.
- The High-Value Exception: Estate Taxes
While the beneficiary does not often have to pay income tax, there are times when the value of the policy is subject to federal or state estate taxes. This generally occurs under one of two conditions; each takes into account whether the deceased legally “owned” the policy at the time of death.
- When the Estate is the Named Beneficiary
If the decedent named their own estate (as opposed to an individual, trust, or entity), the life insurance death benefit is payable directly into the estate. This increases the overall value of the assets in the estate.
If the decedent’s estate value, plus life insurance proceeds, exceeds the high federal estate tax exemption limit, estate taxes are owed to the federal government on that amount above the cap. Currently, this is applied only to very large estates, but several states have much lower thresholds for estate tax.
- Incidents of Ownership
The IRS adds the value of a life insurance policy to the decedent’s taxable estate if the decedent owned any “incidents of ownership” at the time of death. The incidents of ownership relate to control over the policy, including the right to:
- Change the beneficiary.
- Cancel the policy.
- Borrow against the cash value, if applicable.
Ownership by the decedent usually means that, even if the proceeds are paid directly to a designated individual beneficiary, the value will be brought into the estate for tax purposes and may trigger the estate tax.
Strategy to Avoid Estate Tax
The primary strategy to prevent this is transferring policy ownership to a third party, such as an Irrevocable Life Insurance Trust (ILIT). An ILIT owns the policy, removing it from the insured’s taxable estate and ensuring the federal taxes on life insurance death benefits are avoided upon death (as long as the transfer occurred more than three years before death).
- The Structural Exception: Transfers and Ownership Issues
More unusual structures or transfers of life insurance policies can create a tax liability for the beneficiary, according to IRS life insurance rules.
- The “Transfer-for-Value” Rule
If, during their lifetime, a life insurance policy is transferred or sold to another owner for valuable consideration, such as cash, the death benefit proceeds may become taxable to some extent.
The tax-free amount is limited to the money the new owner paid for the policy plus any subsequent premiums paid. Any amount of death benefit received above this cost is taxed as ordinary income.
- The “Goodman Triangle” (Gift Tax)
There are three different people in this scenario for the three roles:
Insured-the person whose life is covered.
Owner – the person who purchased the policy.
Beneficiary-the one who receives the payout.
For instance, if a mother has a policy on her son’s life and names her daughter as the beneficiary, at the death of her son, the IRS could treat the death benefit payout to the beneficiary as a taxable gift from the owner (mother) to the beneficiary (daughter). Under these circumstances, a gift tax liability could attach to the owner, but not the beneficiary, provided the amount exceeds the annual and lifetime exclusion limits.
Generally, the lump-sum death benefit you receive as a beneficiary is tax-free; no one pays taxes on the principal amount. However, if the insurance payout is not immediate and accrues interest on instalments or delays, that interest portion is taxable as ordinary income, and the beneficiary is responsible for paying the tax on that interest. If the large estate of the deceased is the named beneficiary, the payout adds to the estate’s total value and may be subject to federal or state estate tax. Finally, if the policy was transferred to you in return for cash or any other form of valuable consideration during the lifetime of the insured, so-called “Transfer-for-Value Rule”, then the benefit becomes partially taxable as ordinary income, with the beneficiary paying the tax on the gain.
For Policyholders: Review your beneficiary designations and consider an ILIT if your estate size approaches the federal exemption limit. Specifically name your beneficiaries, rather than naming your estate.
For Beneficiaries: Take a lump sum distribution to avoid receipt of taxable interest. If you are offered installment payments, seek the help of a tax professional to understand the income tax ramifications of the interest component.
In conclusion, the tax-advantaged nature of life insurance policies becomes essential in sound financial planning. Whereas the primary death benefit remains a powerful and tax-free way to transfer wealth, awareness of such exceptions is critical for effective planning of life insurance beneficiary taxes.