Are you or a loved one considering getting a life insurance policy? It's helpful to understand why life insurance is important, who benefits and how. Life insurance policies are designed for a policyholder's beneficiaries to receive a payout known as the death benefit upon the policyholder's death. Are life insurance death benefit payouts taxable?
The short answer is no, life insurance death benefit payouts are tax-exempt. Thus, the money goes to your beneficiaries tax-free. The IRS does not require beneficiaries to report money received from a life insurance death benefit as gross income, or anywhere else on their tax returns for that matter.
Situations When Taxes May Occur
Although life insurance death benefit payouts are not considered taxable income, there can be certain situations when taxes may occur. It's helpful to understand these scenarios so you can determine the best type of life insurance policy and estate planning needs for your loved ones.
Taxable Earned Interest
If a beneficiary elects to delay receiving a death benefit payout versus receiving payment immediately, he or she may owe taxes on any earned interest during that period of time.
Income earned from accrued interest payments is considered taxable and is required to be reported on your tax return.
Why would a beneficiary choose to delay receiving a life insurance death benefit?
We all manage money differently. Some people do not have the discipline or desire to manage, save, invest, and/or spend a large lump sum of money wisely. (For helpful tips on increasing your wealth, be sure to check out my top financial products page)
Thus, life insurance companies typically offer beneficiaries the option to receive a life insurance death benefit payout in small, regular incremental amounts over a predetermined length of time. Think of this like receiving a stable allowance on a monthly, quarterly or annual basis.
Over the course of time that the life insurance death benefit payout is delayed, the payout will earn accrued interest. Even if the amount of interest earned is insignificant, it is still considered taxable and must be reported on the beneficiary's tax return.
Estate Or Inheritance Taxes
There may be situations when a life insurance death benefit payout is paid to the policyholder's estate instead of directly to a beneficiary. For example, this could occur if the beneficiary on file for the policy passes away before he or she can receive the payout and no other beneficiaries are on file.
The person(s) who inherits the estate of the deceased policyholder could be subject to estate taxes as a result of the life insurance death benefit payout going into the estate.
Estate taxes can arise when assets transfer from a person to his or her heirs upon death. Heirs can also be subject to inheritance taxes in six states:
- Iowa
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
The good news is there is no federal inheritance tax and surviving spouses are exempt in the six states with inheritance tax. Some states also exempt direct descendents and minors from paying inheritance taxes.
Estate taxes typically only apply to very wealthy estates, especially since the Federal estate tax limits were raised significantly in recent years. The limit is $11.7 million per individual in 2021.
In simple terms, if your estate value will total less than that while including your life insurance death benefit payout, your beneficiaries won't have to worry about paying estate taxes.
Related: How Does A Death Or Suicide Affect The Value Of A House?
Tax-free Life Insurance Death Benefits
Life insurance death benefit payouts are typically not taxable, providing a huge benefit to your beneficiaries upon your death.
Situations when life insurance death benefits could result in taxes include interest income earned on delayed payouts, Federal estate taxes and possibly inheritance taxes if your policy's payout is paid directly into your estate at your death.
Nobody likes to talk about death, but taking the time to understand the benefits of life insurance can provide peace of mind for you and your family.
Get Free Life Insurance Quotes
There are a lot of different options when it comes to purchasing a life insurance policy. Life insurance can provide critical financial relief and help you and your family sleep easier at night.
Thanks to technology, it’s easier than ever to compare term life insurance policies. The most efficient and free way to get competitive life insurance quotes is to check online with PolicyGenius. They are the #1 life insurance marketplace where qualified lenders compete for your business.
You can quickly search for policies across multiple carriers through PolicyGenius’s online portal for free. I’ve know the founders of PolicyGenius for years and they have truly build a fantastic resource for individuals.
About the Author: Sam worked in investment banking at Goldman Sachs and Credit Suisse for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley.
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $265,000 a year in passive income. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too. He started Financial Samurai in 2009 and has grown it to be one of the largest independently owned personal finance sites in the world with over 1 million organic visitors a month.