A life insurance death benefit can help alleviate some of the financial burdens of losing a loved one. After all, the money can help your family replace income, pay off debts, and more. But if a chunk of the life insurance benefit goes toward taxes, it may not be as helpful. So if you’re thinking about getting a life insurance policy, you may be wondering, do beneficiaries need to pay taxes?
Is life insurance taxable?
Life insurance payouts are often not taxable when the beneficiary is a person, organization, or trust that receives a lump sum amount. In addition to the tax-free status of life insurance payouts, the money can be used to help with any financial need, whether that’s paying off a large debt, like a mortgage, covering funeral expenses, or otherwise. For these reasons, life insurance is one of the best ways to provide financial protection for loved ones. But there are unique situations where the beneficiary of a life insurance policy could face taxes.
When do beneficiaries pay taxes on life insurance?
Beneficiaries should be aware of three unique circumstances where some of the money received from life insurance may be taxable.
The policy accrues interest
If a beneficiary receives a life insurance benefit as a lump sum, they won’t need to report it as gross income for tax purposes. But sometimes, a beneficiary may choose to receive the money in installments or defer payment for a period. In these circumstances, the interest portion of the benefit will be taxable. That means beneficiaries could face a smaller tax bill for only the interest income, similar to what one might face with other financial vehicles, like a savings account.
The policyholder, insured, and beneficiary are all different
Frequently, when someone buys a life insurance policy, they are both the policyholder and insured, assigning a beneficiary to receive the proceeds from the policy. But sometimes, a well-meaning loved one or business partner may set up a policy where each party is different. This creates a situation known as the Goodman triangle.
Let’s say your spouse takes out a life insurance policy on you, making your adult child the beneficiary. In this case, your spouse is the policyholder, you are the insured, and your child is the beneficiary. If you pass, from a tax standpoint, the life insurance policy is viewed as a taxable gift from your spouse to your child. And unfortunately, that means your spouse could need to file a gift tax return on the money the child receives.
Keep in mind there are yearly gift tax limits and lifetime gift limits, so often, only those with larger estates will need to worry about this. In 2022, the annual exclusion is $16,000 and the lifetime exclusion is $12,060,000. To avoid this taxable situation entirely, make sure there are only two people or organizations comprising the three roles of insured, policyholder, and beneficiary. And always consult with a tax attorney before setting up a policy where the three roles differ.
The estate is beneficiary
If you fail to name a beneficiary on your life insurance policy, the benefit becomes part of your estate. That means heirs to your estate could face a tax burden if you have a large life insurance policy. However, you can turn this taxable situation into a tax-free benefit by taking care to assign at least one primary and contingent beneficiary.
Keep in mind that estates must be worth at least $12,060,000 in 2022 to be taxable. As a result, many policyholders won’t need to worry about the impact of a life insurance payout on their estate.
How to ensure your life insurance beneficiary won’t pay taxes
There are several steps you can take to increase the chances that your beneficiaries won’t have to pay taxes.
- Name at least one primary and contingent beneficiary: Since a policy payout may be taxable if it goes to your estate, you’ll want to be sure to designate multiple beneficiaries. By including at least one primary and contingent beneficiary, the odds are good that someone will be around to claim the policy’s benefit tax-free.
- Notify your beneficiaries: You’d be surprised at how many life insurance benefits go unclaimed simply because people don’t know they’ve been named a beneficiary! When you assign a beneficiary, tell them and provide the information for your insurance company so they can easily contact the company to file a claim if you pass away.
- Inform beneficiaries about tax advantages of a lump sum payout: Unless you specify otherwise, the beneficiary can decide how they’d like the payment, whether as a lump sum, interest option, annuity option, or otherwise. When beneficiaries take the benefit as a lump sum, they’ll receive a single payment to use however they need most, whether to replace income, cover a mortgage, or pay off debt. Other options, like interest and annuity, could result in taxation on the interest income.
If a beneficiary isn’t sure if their unique situation has tax consequences, the IRS provides a tool to help beneficiaries confirm if their life insurance proceeds are taxable. As you set up a new policy or manage an existing one, it’s smart to consult with a financial adviser or accountant for tax questions and verify the taxable status.
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