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| Not all life insurance benefits are received tax-free. |
Typically, beneficiaries do not have to pay income tax on life insurance death benefits when they are received as a lump sum. However, some insurance companies usually offer beneficiaries a choice of payout options other than a single lump sum. In this case, a portion of these payouts may be considered taxable earnings. There are also other circumstances in which life insurance benefits may be taxed.
Lump Sum Payouts
Life insurance policy proceeds are distributed to named beneficiaries without income tax liability. Beneficiaries who receive a single lump sum as a life insurance death benefit are not obligated to report the payout or include it in gross income calculations. The only exception to this rule would be if a beneficiary received an amount greater than the actual death benefit. Although rare, this situation may occur when the insurance company temporarily places the death benefit in an interest-bearing account while awaiting documentation, or while the beneficiary investigates possible consequences of the various payout options. In addition to the lump sum distribution, the beneficiary would receive any interest generated by the policy proceeds, and that excess is taxable.
Scheduled Payouts
Most life insurance companies offer beneficiaries the option of receiving death benefit proceeds as a series of equal payments over a pre-determined period of time, rather than in a single lump sum. Recipients who select this payout method typically receive more money because the benefit amount is transferred into an interest-bearing account. In those cases, the portion of each payment considered interest earnings above the actual death benefit is fully taxable as ordinary income.
Policies Without Beneficiaries
If you have not declared a beneficiary on your life insurance policy, or if the beneficiary pre-deceases you and you fail to update your designations, your death benefit will be paid to your estate. Even though income taxes are not due on the payout, estate taxes could become an issue if the additional value placed on your estate by the policy proceeds increases the total above the current $5 million exclusion.
Business-Owned Policies
Life insurance policy proceeds received by businesses or other organizations might be taxable. Many companies purchase life insurance on key executives or other employees to prevent substantial losses if that person dies; policies are often purchased on corporate partners to provide adequate capital to buy out a deceased shareholder's family's interest in the business. If specific disclosure documents and guidelines are not properly obtained and followed, the entire death benefit is considered taxable earnings to the company. To avoid taxation of corporate-owned life insurance, the company must obtain the employee's written consent to be covered and acknowledge the size of the death benefit.
From website IRS
Life Insurance Proceeds
Life insurance proceeds paid to you because of the death of the insured person aren't taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract. However, interest income received as a result of life insurance proceeds may be taxable.
Proceeds not received in installments. If death benefits are paid to you in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person's death. If the benefit payable at death isn't specified, you include in your income the benefit payments that are more than the present value of the payments at the time of death.
Proceeds received in installments. If you receive life insurance proceeds in installments, you can exclude part of each installment from your income.
To determine the excluded part, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Include anything over this excluded part in your income as interest.
Example.
The face amount of the policy is $75,000 and, as beneficiary, you choose to receive 120 monthly installments of $1,000 each. The excluded part of each installment is $625 ($75,000 ÷ 120), or $7,500 for an entire year. The rest of each payment, $375 a month (or $4,500 for an entire year), is interest income to you.
Proceeds received in installments. If you receive life insurance proceeds in installments, you can exclude part of each installment from your income.
To determine the excluded part, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Include anything over this excluded part in your income as interest.
Example.
The face amount of the policy is $75,000 and, as beneficiary, you choose to receive 120 monthly installments of $1,000 each. The excluded part of each installment is $625 ($75,000 ÷ 120), or $7,500 for an entire year. The rest of each payment, $375 a month (or $4,500 for an entire year), is interest income to you.
