According to the IRS, life insurance beneficiaries usually don’t have to report life insurance proceeds as taxable income on their tax return. However, some exceptions may require a beneficiary to pay taxes on life insurance interest if the policy accrues interest before disbursement by the life insurance company.
A tax professional from the offices of Levy & Associates Tax Consultants describes life insurance tax exemption and taxable income on life insurance interest in the paragraphs below. Keep reading to learn more about life insurance proceeds subject to income tax.
Life Insurance Proceeds vs. Taxable Income
If your life insurance company pays life insurance proceeds directly to your beneficiaries immediately upon your death, your beneficiaries likely won’t pay taxes on those death benefits. The IRS lists a tax exemption on life insurance proceeds where beneficiaries do not need to include a life insurance policy death benefit as taxable income.
However, there are exceptions. If the insured person has the life insurance company hold some or all of the death benefits for a period after death, the policy balance will accrue interest. Only the interest is subject to income tax reporting by the beneficiary.
Additionally, suppose the insured person names their estate as the beneficiary. In that case, this bypasses the tax exemption, and heirs would need to pay estate taxes upon receiving their inheritance from the estate, including their share of the life insurance policy balance.
What Parts of the Life Insurance Proceeds Are Subject to Income Tax?
Depending on when and how the insurance company pays out the life insurance proceeds, beneficiaries may have to pay some taxes on life insurance benefits. These instances include:
- Interest income
- Inheritance and estate taxes
- Transfer of ownership or gift taxes within three years of the passing of the insured person
If the insured person asks the insurance company to hold the death benefits for a period before disbursement, or you elect to receive payment in installments, the portion of the benefits held by the insurance company will accrue interest. You will need to report and pay income tax on the interest, not the initial policy benefits.
If the insured person names their estate as the beneficiary of their life insurance policy and names beneficiaries of their estate as part of their will or trusts, beneficiaries of their estate may have to pay estate taxes on their inheritance if the value of the estate is over $12.06 million.
As the insured person and owner of the policy, you may transfer ownership of the life insurance policy to a trusted third party. You may even transfer ownership of the policy to the beneficiary. The new owner of the policy becomes responsible for paying the policy premiums. You can gift up to $16,000 to the new policy owner to cover your policy’s premiums.
If you transfer ownership of your life insurance policy, beneficiaries may have to pay a gift tax if the total gift amount totals more than $12.06 million. However, if you transfer ownership of your policy and pass away before three years have passed, the balance of death benefits transfers to your estate.
Contact the Tax Offices of Levy & Associates Tax Consultants for Help With Taxes on Life Insurance
If you have a tax problem you need help with, contact the offices of Levy & Associates Tax Consultants at 1-800-TAX-LEVY or contact us online for a free tax review.