As a general rule, proceeds from a life insurance policy are not taxed as income to the recipient. Whether the proceeds take the form of death benefits or Accidental Death & Dismemberment (AD&D) benefits to the insured, those proceeds are not considered income by the IRS.
There are three scenarios where the recipient may be taxed on insurance proceeds, however. This post describes those scenarios and instructs you as the insured on how to avoid them, written from the office of a busy life insurance beneficiary attorney.
A Life Insurance Beneficiary is Late in Claiming the Death Benefit
How life insurance usually works is that the insured dies, and their beneficiary or beneficiaries claim the death benefit shortly thereafter. However, there are circumstances where the insurance company must hold the death benefit, such as when:
• the beneficiary or beneficiaries cannot be found;
• there is a beneficiary dispute;
• the insurance company is investigating the cause of death of the insured;
• the death of the insured is subject to a criminal investigation;
• the insured died on foreign soil;
• the beneficiary asks the insurance company to hold the death benefit.
If the insurance company must hold the death benefit while these issues are resolved, the death benefit will accrue interest, and that interest is taxed as income to the beneficiary.
If you are a life insurance beneficiary, the way to avoid being taxed on interest the death benefit accrues is to timely claim the death benefit. However, if you are not in control of whatever is delaying the death benefit, you may have no choice but to pay that tax.
The Death Benefit is Paid to the Estate of the Insured
When an insured has not been advised otherwise, the insured may name their estate as the beneficiary of their life insurance policy. When the death benefit is paid into the insured’s estate, and the estate is dispersed to the insured’s heirs, the heirs may be taxed on their inheritance. This also applies to other accounts such as IRA accounts and annuities.
Estate taxes are not triggered unless the value of the estate is $11.58 million in 2020. The maximum estate tax rate is 40%. While the death benefit of your policy may be well below $11.58 million, if adding the value of any real property, retirement accounts, savings, collections, and other belongings approaches that number, you need to plan ahead.
One way to avoid estate tax on insurance proceeds is to transfer ownership of the policy because if someone other than you owns the policy at the time of your death, the insurance proceeds will not be included as part of your estate. Here’s how to transfer ownership:
• Choose a competent adult as the new owner. That person can be a beneficiary.
• Call your insurance company for assignment (transfer of ownership) forms.
• Obtain written confirmation of the assignment from your insurance company.
Know that you will give up the right to make any changes to the policy, although you could ask the new owner to make changes for you. Change of ownership is irrevocable. Also, the new owner must pay premiums on the policy. You can fund those payments by gifting the new owner an amount of up to $15,000 with no tax ramifications.
Another way to avoid estate tax on insurance proceeds is to form a life insurance trust. This is often done when the intended beneficiary of the policy is a minor child or an adult child with special needs. You can name a trusted friend or family member as trustee.
The Insured Withdraws Funds from Their Whole Life Insurance Policy
Cash-value life insurance policies such as whole life or universal life insurance policies accrue value, which is tax-deferred. Such policies frequently come with the right to withdraw or borrow from the policy. However, if the insured withdraws more than they contributed in premium payments, called the “basis,” the overage will be taxed to the insured as income.
Under most circumstances, planning ahead is the way you and your beneficiaries can avoid paying taxes on the proceeds from life insurance.