Do Life Insurance Beneficiaries Have to Pay Taxes?

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The death benefit received by the beneficiary of a life insurance policy is generally not considered taxable income, and the beneficiary is not required to pay taxes on it.

However, there are a few circumstances in which the beneficiary gets taxed on some or all of the proceeds of a policy. If the policyholder chooses to have the benefit held by the life insurance company for a length of time rather than being paid out immediately upon his death, the beneficiary may be required to pay taxes on the interest earned during that time. When a death benefit is provided to an estate, the person or people who inherit it may be subject to estate taxes.

However, there are various ways to avoid these estate taxes, which are explained below.

TAKEAWAYS IMPORTANT

• When a beneficiary of a life insurance policy receives the death benefit, there are usually no taxes due; however, there are a few exceptions.
• If the policyholder has requested that the insurance company keep the policy for a few months before transferring it to the beneficiary, the interest collected during that time is normally taxable.
• If the policyholder has designated an estate as the beneficiary of the policy rather than an individual, the person or people who inherit the estate may be subject to inheritance taxes.

Interest Earnings

Interest income is virtually always subject to taxation at some time. There is no exemption when it comes to life insurance. This means that if a beneficiary receives life insurance proceeds after a time of interest accumulation rather than right after the policyholder's death, the beneficiary must pay taxes on the interest rather than the total benefit. The beneficiary will owe taxes on the $50,000 growth if the death benefit is $500,000 and it earns 10% interest for a year before being paid out.

Inheritance and Estate Taxes

Choosing "payable to my estate" as the beneficiary of a contractual agreement, such as an IRA account, an annuity, or a life insurance policy, appears to be a common mistake made by investors. When you name the estate as your beneficiary, however, you forfeit the contractual benefit of naming a real person and submit the financial product to probate. Leaving assets to your estate enhances the value of the estate and may subject your heirs to exorbitant estate taxes.

The value of life insurance proceeds insuring your life is included in your gross estate under Section 2042 of the Internal Revenue Code if the proceeds are payable: (1) to your estate, either directly or indirectly, or (2) to named beneficiaries if you had any "incidents of ownership" in the policy at the time of your death.

Using a Transfer of Ownership to Avoid Taxes

Thanks to the Tax Cuts and Jobs Act of 2017, which raised the exemption amount to $11.4 million in 2019, rising to $11.58 million in 2020 and $11.70 million in 2021, many estates will be tax-free. In the meantime, the maximum estate tax rate is set at 40%.

The ownership of the policy at the time of the insured's death determines whether life insurance proceeds are included in the taxable estate for those estates that would owe taxes. You must transfer ownership of your life insurance policy to another person or company if you want the proceeds to be tax-free.

When considering an ownership transfer, keep the following guidelines in mind:

1. Choose a responsible adult or entity as the new owner (it might be the policy beneficiary), then contact your insurance company for the appropriate assignment, or transfer of ownership, documents.
2. The policy's premiums must be paid by the new owners. In 2020, though, you can give up to $15,000 per person, so the recipient may be able to use some of the money to pay premiums.
3. You shall relinquish all future rights to make modifications to this policy. If a child, family member, or friend is listed as the new owner, the new owner can make modifications at your request.
4. When naming the new owner, be wary of divorce scenarios because ownership transfer is an irreversible event.
5. As proof of the ownership change, get written confirmation from your insurance carrier.

Avoiding Taxes by Using Life Insurance Trusts

The creation of an irrevocable life insurance trust is a second approach to keep life insurance proceeds out of your taxable estate (ILIT). You cannot be the trustee of the trust or retain any rights to revoke the trust in order to execute an ownership transfer. The insurance will be kept in trust in this situation, and you will no longer be considered the owner. As a result, the proceeds are excluded from your estate.

Why do you want to own a trust rather than transferring ownership to someone else? You might want to keep some legal control over the policy for a variety of reasons. Perhaps you're concerned that an individual owner will fail to pay premiums, whereas you can assure that all premiums are paid on time in the trust. If the revenues are to be distributed to minor children from a prior marriage, an ILIT allows you to appoint a trusted family member as trustee to manage the funds according to the trust document's conditions.

Life Insurance Policy Ownership Regulations

When an insured individual dies, the IRS has devised guidelines to help determine who owns a life insurance policy. The three-year rule, which specifies that any gifts of life insurance policies issued within three years after death are still liable to federal inheritance tax, is the primary regulation supervising appropriate ownership in the financial industry. This is true for both the transfer of ownership to another person and the creation of an ILIT.

Any occurrences of ownership by the individual who transfers the policy will also be investigated by the IRS. The original owner must give up all legal rights to alter beneficiaries, borrow against the policy, surrender or cancel the policy, or choose beneficiary payment options when transferring the policy. Furthermore, the original owner is not required to pay the premiums in order for the policy to remain in force. These actions are regarded to be a part of asset ownership, and if any of them are carried out, the tax benefit of transferring the assets will be lost.

Even if a policy transfer meets all of the requirements, taxation may nevertheless apply to portion of the transferred assets. Gift taxes will be levied and due at the time of the original policyholder's death if the current cash value of the policy exceeds the $15,000 gift tax exclusion.

Final Thoughts

Individuals are frequently covered by life insurance policies with death benefits ranging from $500,000 to several million dollars. You might be startled by the size of your estate if you factor in the worth of your home, retirement accounts, savings, and other possessions. Some people may face an estate tax problem if more years of growth are taken into account.

A suitable strategy is to maximize your gifting potential and to transfer policy ownership at a low or no gift-tax cost wherever practicable. Your estate could save a large amount of tax if you live another three years following the transfer.