The death benefit from a life insurance policy is not considered taxable gross income when the beneficiary receives it. The recipient may be subject to taxes on some or all of a policy's proceeds under certain circumstances.
The beneficiary can be required to pay taxes on the interest earned during the holding period if the policyholder chooses to postpone the benefit payout and the life insurance company keeps the money.
When a death benefit is provided to an estate, the inheritor(s) may be responsible for paying estate taxes.
When Does a life insurance benefit become taxable?
Interest income is usually always subject to taxation at some time. The same applies to life insurance. This implies that the beneficiary must pay taxes on the interest rather than the total benefit when receiving life insurance funds during a period of interest accumulation rather than immediately following the policyholder's passing.
The beneficiary will be responsible for paying taxes on the $50,000 increase, for instance, if the death benefit is $500,000 and it earns 10% interest for a year before being paid out.
Taxes on estates and inheritances
Making "payable to my estate" the beneficiary of a contract, such as an individual retirement account (IRA), an annuity, or a life insurance policy, is a mistake that investors tend to make regularly.
The contractual benefit of naming a real person is lost when you designate the estate as your beneficiary, and the financial product is subjected to the probate procedure. Giving things to your estate can result in extremely expensive estate taxes for your heirs and enhance the estate's value.
According to Internal Revenue Code Section 2042, if you have life insurance proceeds that are receivable, their value is included in your gross estate.
either directly or indirectly to your estate
If you had any "incidents of ownership" in the policy at the time of your death3, to the named beneficiaries.
Some Advice on How to Avoid a Life Insurance Benefit Tax
Avoid Taxes by Transferring Ownership
Because of the Tax Cuts and Jobs Act (TCJA) of 2017, which boosted the exemption amount to $11.7 million for 2021 and $12.06 million for 2022, few estates will be subject to federal taxes. The top estate tax rate, meanwhile, is restricted to 40%.
The ownership of the policy at the time of the insured's death determines whether life insurance proceeds are included as part of the taxable estate for estates that will owe taxes. You must transfer ownership of your policy to a different person or organization if you want your life insurance proceeds to be exempt from federal taxation.
The following principles should be kept in mind when thinking about an ownership transfer:
Select a responsible adult or entity to serve as the new owner (the policy beneficiary may qualify), then contact your insurance provider to request the appropriate assignment or transfer of ownership documents.
New owners must pay the premiums for the policy. The recipient could use some of this gift to cover premiums, as you can only give each recipient up to $15,000 in 2021 and $16,000 in 2022.
You will forfeit all future rights to modify this policy. However, if a child, relative, or friend is designated as the new owner, adjustments may be made upon your request by the new owner.
When arranging to identify the new owner, be mindful of divorce situations since ownership transfer is an irrevocable occurrence.
Obtain written confirmation of the ownership change from your insurance provider.