Life insurance proceeds – aka death benefit – at the death of the insured are generally tax free. But there are circumstances that will trigger some tax on what a beneficiary receives. Here are some…
The lump-sum payment for the full face value of the life insurance policy is generally free of income taxes to the beneficiary. That’s one of the long time benefits of insurance.
But if the insurance policy is subject to estate taxes of the deceased owner, the beneficiary may receive a reduced amount since estate tax takes precedent. This happens when the owner of the insurance policy maintains effective control over it until he dies. That is he can change the beneficiary of it at any time or he has no beneficiary designated since he wants it to be in his estate to help pay estate taxes or bolster his estate for his will’s beneficiaries.
The insurance proceeds may be taxable where the policy had been previously transferred from original owner to another for valuable consideration. In this case he transferred it to another for generally money back to himself. This doesn’t include gifting the policy which is transferred without valuable consideration by definition. You’ll need to check with a tax expert if it was transferred for valuable consideration.
Now, any time you, as the beneficiary, take less than the full face value (the death benefit) as a lump-sum, the remainder, which is held by the insurance company, earns interest. You may take the proceeds of this over a period of years, or for the rest of your life. In this case, any amount you receive in excess of that full face value will be taxed as ordinary income.
*Here’s how installment payout are taxed for a policy who’s full face value was $130,000:
A life insurance policy has a surviving wife, daughter, and nephew all as beneficiaries. According to the policy, the wife is entitled to a lump sum of $60,000 while the daughter and nephew are each entitled to a lump sum of $35,000 which, together, accounts for the full $130,000 death benefit.
Under the installment options, the wife chooses to receive $5,000 a year for the rest of her life. (She has a 20-year life expectancy.) The daughter and the nephew each choose a yearly payment of $5,000 for 10 years. This is how each yearly installment is taxed:
The principal amount spread to each year is $3,000 ($60,000 ÷ 20-year life expectancy). Subtracting $3,000 from the yearly $5,000 payment makes her annual taxable income $2,000. So she will have received an additional $40,000 in interest in excess of her $60,000 death benefit.
*Daughter and Nephew:
Both are taxed the same way. The principal amount spread to each of the 10 years is $3,500 ($35,000 ÷ 10-year installment period). Subtracting this $3,500 from the yearly $5,000 installment gives the daughter and the nephew taxable income of $1,500 each year. So each will receive $15,000 of interest in excess of their $35,000 death benefit.