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When Is Life Insurance Taxable to Beneficiaries?

Three BIG Reasons to Have an Estate Plan
When beneficiaries receive a payout from a life insurance policy, they typically don’t have to pay taxes. However, there are a few situations where a portion of the life insurance benefit is taxable to the beneficiary.

When people purchase life insurance policies, they designate a beneficiary who will benefit from the policy’s proceeds. When the life insurance policyholder dies, the policy’s beneficiary then receives a payout known as the death benefit. Beck, Lenox & Stolzer Estate Planning and Elder Law helps clients with additional estate planning needs when there is a life insurance inheritance. In most instances, there are no tax consequences, but there are some situations when life insurance is taxable to beneficiaries. Read more about that in Yahoo Finance’s recent article entitled “Will My Beneficiaries Pay Taxes on Life Insurance?” .

The article states that the big advantage of buying a life insurance policy is that, upon death, your beneficiaries can get a substantial lump sum payment without taxation, unless the amount of the life insurance pushes your estate above the applicable federal estate tax exemption. In that case, your estate will need to pay the tax.

While death benefits are usually tax-free, there are a few situations where the beneficiary of a life insurance policy may have to pay taxes on the lump sum payout. When you earn income from interest, it’s typically taxable. Therefore, if the beneficiary decides to delay the payout instead of receiving it right away, the death benefit may continue to accumulate interest. The death benefit won’t be taxed. However, the beneficiary will typically pay taxes on the additional interest.

If a life insurance policyholder decides to name their estate as the death benefit beneficiary, the estate could be subject to taxation. When you don’t designate a person as your beneficiary, the proceeds from the life insurance policy are subject to Section 2024 of the IRS code. That says if the gross estate incorporates proceeds of a life insurance policy, the value of a life insurance policy must be payable to the estate directly or indirectly or to named beneficiaries (if you had any “incidents of ownership” throughout the policy term).

The proceeds of a life insurance policy may also pass to the estate if the beneficiary dies, and there are no contingent beneficiaries. If you have a will in place, the proceeds will be paid out according to the terms of the will. If there’s no will in place, the probate court decides the way in which to distribute your assets.

The individual insured on a life insurance policy and the policyholder are usually the same person. The policyholder then names a beneficiary. However, a gift tax may apply if the insured, the policyholder and the beneficiary are three different parties. Because the IRS assumes the death benefit was a gift from the policyholder to the beneficiary, you might have to pay gift taxes on the death benefit.

Beneficiaries usually won’t have to pay taxes on life insurance proceeds. However, some situations can result in a taxable event. Be sure that your beneficiary designations are clearly outlined in the policy to avoid taxation. If you need guidance on your estate planning, especially in light of a pending inheritance, feel free to contact Beck, Lenox & Stolzer. Click Help to schedule a complimentary phone call with Jayson Lenox or Caroline Daiker.

Reference: Yahoo Finance (Jan. 17, 2023) “Will My Beneficiaries Pay Taxes on Life Insurance?”

 

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