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Having a life insurance policy allows you the peace of mind of knowing that your family will have a financial safety net in case of your passing. But many people worry about whether or not life insurance is taxable, as they do not want to burden their beneficiaries with a tax bill. Luckily, in most cases, life insurance proceeds are not considered taxable income — though there are some exceptions to be aware of.
If you’re wondering if life insurance proceeds are taxable, the IRS states that proceeds from a life insurance policy are not generally considered gross income for the beneficiary. However, there are caveats. For example, interest received by a beneficiary as a result of the insured’s death should be reported as income. A beneficiary may also need to report some of the payout as taxable income if they receive it in exchange for cash or something else of valuable consideration, up to the total amount of what was expended.
Here are some exceptions when you may have to pay tax:
There are two ways the death benefit can be paid: as a single lump sum or in installments. Some people prefer to receive money over time to avoid spending the full amount. But they should be aware that the interest is taxable.Jonathan Holloway, co-founder of NoExam.com, a digital life insurance brokerage explains, “If the payout is paid in installments, the interest that accrues on the payouts is taxable. The death benefit is not taxable, only the interest on installments.”
If the policyholder names an estate as the beneficiary in a life insurance policy, the process gets more complicated. If the death benefit pushes the estate’s value over $12,920,000, your beneficiaries will have to file IRS Form 706, also named the “United States Estate (and Generation-Skipping Transfer) Tax Return.” Leaving the proceeds to an estate adds to its value, which could lead to higher estate taxes for your heirs.The proceeds left to a beneficiary may be taxable under the decedent’s estate, both federally and on the state level in some cases, as well. An estate tax may also be owed in cases where the beneficiary is not the estate.
There is no set rule about what you should do with your life insurance proceeds. It may be tempting to go on a spending spree when you first receive the money, but putting off spending for a while and consulting with a financial advisor may be a wise choice.
Thomas D. Currey, owner of TDC Financial Services in Grand Prairie, Texas, and chair of the board of directors of the nonprofit Life Happens, warns individuals to be careful with their newly acquired windfall. “The one word of caution I’d have is that when anyone comes into a large sum of money, it’s easy to spend first and ask questions later,” Currey says. “Seeking counsel to help you assess what your current needs are and how to make it go as far as possible is always a good idea.”
By now you know that in most scenarios, life insurance proceeds are not taxable. As for what to do with the death benefit you receive, here are some ideas:
If you have credit card debt or you’re paying off student or personal loans with high interest rates, paying off the debt can save you money on the interest you’re paying. It helps to be systematic in this process. You may want to prioritize debts according to the highest interest rates charged and pay these first.
Create a college fund for your kids by putting some money into a 529 college savings plan. The funds can be withdrawn tax-free to pay for qualified school expenses. If possible, when paying for education, use any available tax credits first. After this, consider using 529 funds on remaining expenses, while watching out for penalties. You need to withdraw 529 funds during the year they will be used for school expenses.
If you are living paycheck to paycheck, an emergency fund could take some of the pressure off. Experts recommend having between three to six months’ worth of living expenses in your emergency fund in case you lose your job, your car breaks down or you become ill and unable to work. In creating a sufficient emergency fund, it can be helpful to use the adage “pay yourself first,” wherein you agree to set aside a certain amount in the fund each month before any other bills are paid.
Generally, the proceeds from a life insurance policy that you receive as the beneficiary are not considered gross income and do not have to be reported on your income taxes. However, any interest earned is taxable and should be reported.
Although life insurance proceeds are usually tax-free, this isn’t the case 100 percent of the time. This tool from the IRS can help you determine if you have to pay taxes on a life insurance payout.
You won’t receive a 1099 for life insurance proceeds because the IRS doesn’t typically consider the death benefit to count as income.
Life insurance premiums are not tax deductible unless they are paid to someone else (for example, as part of an alimony agreement).
Although insurance premiums are typically not tax deductible, certain portions of employee life insurance premiums paid by a business can be tax deductible. Additionally, funds in an amount equal to premiums paid can be tax exempt when a policy is surrendered.
In most cases, creditors cannot garnish your life insurance proceeds to cover your outstanding debt after you die. However, there are some exceptions. Your creditors can use your life insurance proceeds to pay your debt if you fail to name a beneficiary on your policy. The same is true if you name your estate as the beneficiary rather than a person (or persons). When purchasing a life insurance policy, you may want to discuss your beneficiary selection with your agent to learn exactly how your policy will pay out upon your death.
