Life insurance is a critical part of ensuring that beneficiaries have a measure of financial stability after their loved one dies. A death benefit can help you replace your loved one’s income and pay for their end-of-life expenses. In most cases, you won’t have to pay taxes on the life insurance payout but there are certain situations in which you may be responsible for tax payments.
When You Won’t Pay Taxes on Life Insurance Payouts
You won’t pay taxes as the beneficiary of a life insurance policy (term, whole, or other type of policy) provided you take the money and don’t invest it or put it in an interest-earning account. Per the IRS, you don’t have to report the money as income on your federal tax return.
Situations When Life Insurance Payouts May Be Taxed
In most cases, you won’t have to pay taxes on a life insurance benefit you receive from the passing of a loved one. However, there are specific situations that may be taxed.
You Paid To Take Over the Policy
An exception to the beneficiary tax rule exists under another circumstance as well. The original owner of the policy—typically the insured—might sign ownership of the policy over to someone else. The named beneficiary on the policy, either you or another individual, would owe taxes on the benefits if you paid anything in exchange for ownership of the policy.
Calculating the taxes you owe in this case is extremely complicated. You should seek the advice and guidance of a tax professional.
You Receive a Delayed Payout
Some beneficiaries leave life insurance proceeds on deposit with the insurance company. They draw periodic payments from the balance. This type of arrangement also earns interest and that interest is taxable. For example, you might elect to receive $3,000 a month. The portion of that $3,000 that represents interest earned must be reported on your tax return.
You can calculate the taxable portion by dividing the total amount on deposit with the insurance company by the number of installment payments you’re to receive. The result is how much of your installment payment is tax-free. Any amount above that figure is considered taxable.
The insurance company should issue you a tax Form 1099-INT at year’s end, reporting exactly how much of your payments represent interest. The IRS will receive a copy, too.
You Qualify for Net Investment Tax
Depending on the amount of interest or investment gains you earn from investing your payout, you may have another tax liability in addition to regular income tax: the net investment income tax. This tax has a rate of 3.8% on certain investment gains, including interest. But this tax is only imposed if your modified adjusted gross income, including interest and investment income, exceeds certain thresholds: $200,000 if you’re single, $125,000 if you’re married filing separately, or $250,000 if you’re married and file a joint return.
Earnings From Investing or Saving the Payout
Let’s say you split up your $300,000 insurance payout and invest half of it in stocks and save the other half in an interest-earning savings account. Any interest you earn must be reported on your tax return. Likewise, if your invested money increases in value from $150,000 to $180,000 and you sell your stock, you’ll pay taxes on the $30,000 you gained if your taxable income is $78,750 or higher, in most cases. The only part of the insurance payout that’s tax-free is the value of the policy on the date of death, according to the IRS.
- The date-of-death value of life insurance proceeds is not taxable to the beneficiary.
- A beneficiary would have to report and pay taxes on any interest earned or taxable gains made from the life insurance proceeds after receiving the money.
- Delayed payouts could be taxable if the payout earned interest during the delay.
- In some cases, the returns you earn on an invested payout could qualify you for the net investment income tax.