Owning a life insurance policy can be an effective way to ensure that your loved ones are provided for if you die prematurely. You pay premiums on the policy, and if the policy is still in force at your death, the beneficiary of your choice collects the death benefit. One of the benefits of life insurance is that the premiums are low compared to the financial hardship on your family if you were to die unexpectedly. This is especially true for younger policyholders.
Whether the policy proceeds might be subject to income taxes or estate taxes depends on how the policy is owned and how the beneficiary is named.
Read on to learn when your beneficiaries might have to pay taxes on the death benefit.
Income Tax Implications
The general rule is that life insurance beneficiaries don’t have to report policy proceeds as taxable income. For example, if you purchase a life insurance policy and name your spouse as the beneficiary, and your spouse receives the payout upon your death, he or she does not include the proceeds as taxable income on his or her tax return. But there are a few situations where the death benefit is taxable.
Exceptions to Income-Tax-Free Proceeds
Two important caveats exist for the general rule that life insurance proceeds won’t be taxed. The first caveat is that any interest paid on life insurance benefits counts as taxable interest. For example, if the decedent died on Feb. 1 but the proceeds weren’t paid to the beneficiary until March 1, the life insurance company pays the beneficiary the proceeds plus one month’s worth of interest. The beneficiary pays tax on that interest.
The second caveat comes into play if the beneficiary purchased the life insurance policy from the original owner. In that case, the proceeds are generally taxable to the extent they exceed the amount paid for the policy, including additional premium payments made after the purchase. For example, if you purchased a policy from another person for $20,000, paid an additional $5,000 in premiums, and then received a $60,000 payout, you would recognize $35,000 in taxable income — the payout less the $25,000 you paid.
Estate Tax Implications
Life insurance proceeds might be included in your taxable estate upon your death if:
- You own the policy
- The proceeds are payable to your estate
- You had any incidents of ownership in the policy
Incidents of ownership include the right to change the ownership of the policy, change or cancel the policy, or change the beneficiary of the policy. But the federal estate tax exemption is currently $11.2 million per person, so very few people will have to worry about owing estate taxes. In the event you do have a taxable estate, consider putting the policy into an irrevocable life insurance trust to minimize your estate tax.