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- The payout from a life insurance policy is generally not subject to income tax
- There are some exceptions for earned interest and estate taxes
- If the beneficiary is an estate rather than a person, you may pay taxes
According to the old Benjamin Franklin quote, “nothing is certain except death and taxes.” But when dealing with a significant loss, the last thing you want to worry about is writing a check to the IRS.
Luckily, you shouldn’t need to. In most cases, the beneficiaries (the people who receive the payout from a life insurance plan) do not pay income tax on the money. It also means you don’t need to factor in extra to cover a tax bill when calculating the value of the life insurance you should buy.
However, there are some instances when you may need to pay tax on life insurance proceeds. Here’s how it works.
Life insurance proceeds aren’t taxable income
Here in the US, our tax system centers around your income. You only need to pay income tax if you have income. The more income you have, the more taxes you pay (at least in theory). That’s why we all must report our income on our tax forms.
According to the IRS, life insurance proceeds are not taxable income in most cases. That means you don’t need to report it or give the IRS a cut. This is specific to income tax. Unfortunately, the IRS has many ways to collect taxes, as do individual states. If you’re inheriting money, we recommend talking to a certified tax professional to be on the safe side. In general, though, there are a few exceptions to the rule with federal taxes.
You will pay taxes on any interest earned
Most people who get a life insurance settlement collect a lump sum, usually within weeks after their loved one dies. If there is a delay in paying, the company will likely pay you interest, which is taxable. Some life insurance plans also accrue interest through the life of the policy. However, the withdrawal tax would depend on how many and the size of your withdrawals.
In terms of the interest generated after the claim filing, the life insurance company might choose to investigate your claim. In that case, it will owe you interest if the payment is delayed for more than the time stipulated in the contract (usually 30 days after it receives proof of the death).
In other cases, people opt for a life insurance annuity rather than a lump sum. An annuity provides scheduled payments for smaller parts of the total settlement. The life insurance company will pay you interest on the death benefit remaining in its account. This works in much the same way as leaving money in the bank. While the principal sum is not taxable, the interest it earns will be subject to federal taxes.
The life insurance company will provide the paperwork you need to report the interest on your taxes. We understand that tax filing is confusing, especially with all the annual changes. However, finding a good tax professional is crucial to avoid audits.
Proceeds left to an estate may be taxed if the estate is large
Frequently, people will list their estate as a beneficiary of the policy. This may seem simple at the time. Rather than naming an individual or individuals, you say when you die, your life insurance payout should go to your estate. Then, it can be divided among your heirs.
However, this could open the payout up to taxation. But don’t worry yet. As of 2023, estates are only taxed if they are worth at least $12.92 million. The size requirement is a moving target, meaning it could go up or down in the coming years. For the average Joe in 2023, you can leave your life insurance policy to your estate, and it can still pass income tax-free. If your aunt, parent, cousin, or other loved one leaves you a significant amount, ensure you’re getting the right advice from a certified professional. A hefty tax lien could affect your life significantly, keeping you from getting certain loans until it’s satisfied.
Tax professionals can help you get the most from life insurance
It’s true that, in most cases, life insurance proceeds aren’t taxed as income. However, tax situations can be complicated, especially when dealing with someone else’s estate. Income tax is one small piece of the larger puzzle, and we cannot go into all the laws surrounding life insurance and taxes.
A knowledgeable tax professional with experience in estate law can help you get everything you’re entitled to from a life insurance policy. More importantly, professionals minimize the tax implications for beneficiaries and protect you from future audits, penalties, and legal fees.
A large life insurance payout could change beneficiaries’ lives. The life boost is often the motivation behind considerable death benefits. If your tax professional is also a financial planner, we recommend talking to them about investing your inheritance for maximum returns for the rest of your life.