Do You Pay Tax on Life Insurance Payout?

The death benefit from a life insurance policy is not considered taxable gross income when the beneficiary receives it. The recipient may be subject to taxes on some or all of a policy's proceeds under certain circumstances.

The beneficiary can be required to pay taxes on the interest earned during the holding period if the policyholder chooses to postpone the benefit payout and the life insurance company keeps the money.

When a death benefit is provided to an estate, the inheritor(s) may be responsible for paying estate taxes.

When Does a life insurance benefit become taxable?

Interest Earnings

Interest income is usually always subject to taxation at some time. The same applies to life insurance. This implies that the beneficiary must pay taxes on the interest rather than the total benefit when receiving life insurance funds during a period of interest accumulation rather than immediately following the policyholder's passing.

The beneficiary will be responsible for paying taxes on the $50,000 increase, for instance, if the death benefit is $500,000 and it earns 10% interest for a year before being paid out.

Taxes on estates and inheritances

Making "payable to my estate" the beneficiary of a contract, such as an individual retirement account (IRA), an annuity, or a life insurance policy, is a mistake that investors tend to make regularly.

The contractual benefit of naming a real person is lost when you designate the estate as your beneficiary, and the financial product is subjected to the probate procedure. Giving things to your estate can result in extremely expensive estate taxes for your heirs and enhance the estate's value.

According to Internal Revenue Code Section 2042, if you have life insurance proceeds that are receivable, their value is included in your gross estate.

• either directly or indirectly to your estate

• If you had any "incidents of ownership" in the policy at the time of your death3, to the named beneficiaries.

Some Advice on How to Avoid a Life Insurance Benefit Tax

Avoid Taxes by Transferring Ownership

Because of the Tax Cuts and Jobs Act (TCJA) of 2017, which boosted the exemption amount to $11.7 million for 2021 and $12.06 million for 2022, few estates will be subject to federal taxes. The top estate tax rate, meanwhile, is restricted to 40%.

The ownership of the policy at the time of the insured's death determines whether life insurance proceeds are included as part of the taxable estate for estates that will owe taxes. You must transfer ownership of your policy to a different person or organization if you want your life insurance proceeds to be exempt from federal taxation.

The following principles should be kept in mind when thinking about an ownership transfer:

• Select a responsible adult or entity to serve as the new owner (the policy beneficiary may qualify), then contact your insurance provider to request the appropriate assignment or transfer of ownership documents.

• New owners must pay the premiums for the policy. The recipient could use some of this gift to cover premiums, as you can only give each recipient up to $15,000 in 2021 and $16,000 in 2022.

• You will forfeit all future rights to modify this policy. However, if a child, relative, or friend is designated as the new owner, adjustments may be made upon your request by the new owner.

• When arranging to identify the new owner, be mindful of divorce situations since ownership transfer is an irrevocable occurrence.

• Obtain written confirmation of the ownership change from your insurance provider.

Gift Duty

Given that the insured and the policy owner are typically the same people, gift tax may apply if three separate people are identified as the policy's certified, policy owner, and beneficiary.

However, the IRS will determine that the death benefit amount was transferred from the policy owner to the beneficiary if the insured is someone other than the policy owner, and you would be required to pay gift tax on the sum.

The gift tax is due once you pass away, but the beneficiary of the death benefit won't have to pay it unless it is more than $12.06 million, including any gifts made of more than $16,000 per year.

Tax Avoidance Using Life Insurance Trusts

Making an irrevocable life insurance trust is a second strategy to keep life insurance proceeds out of your taxable estate (ILIT). You cannot be the trustee of the trust and you may not maintain any powers to revoke the trust to execute an ownership transfer. You will no longer be regarded as the policy's owner in this situation because the insurance is held in trust. As a result, the money won't be counted toward your estate.

Why not simply transfer ownership to a trust instead of doing so? For example, you might still want to have some legal control over the policy. Perhaps you worry that an individual owner will neglect to make premium payments, but you can control premium payments through a trust.

When minor children from a previous marriage are the intended beneficiaries, an ILIT enables you to appoint a dependable family member as trustee to manage the funds following the conditions of the trust agreement on behalf of the children.

Does Money Receive as a Beneficiary Subject You to Taxes?

On money received as a beneficiary of a life insurance policy, taxes are typically not due.

Do You Pay Taxes on Life Insurance Money You've Been Given?

No. Unless the life insurance benefit includes interest, you are not required to pay taxes on money that you inherit

through a life insurance policy. You might be required to pay taxes on the interest if that occurs.

How Can I Avert Taxes on the Proceeds of My Life Insurance?

Estate and income taxes are not levied on life insurance proceeds.

Do I Have to Tell the IRS About My Inheritance?

The IRS does not often require inheritances to be reported.

Conclusion

People frequently have life insurance policies with death payments ranging from $500,000 to several million dollars. You might be shocked by the size of your estate if the worth of your house, retirement funds, savings, and other possessions are factored in. If more years of growth are taken into account, some people can have an estate tax problem.