In general, life insurance proceeds paid to a beneficiary are tax free. However, there are circumstances where the IRS will tax life insurance proceeds. Some of these circumstances include interest income received, estate taxes, and transfers. Therefore, in addition to listing beneficiaries properly on life insurance policies as discussed in the article The Need to Properly List Beneficiaries on a Life Insurance Policy, a policy owner must also understand the tax implications of their policy.

Life Insurance Proceeds and Interest Income

Basically, the IRS will tax as interest income any benefits received that exceeds the amount payable to the beneficiary. In the IRS Publication 525, Taxable and Nontaxable Income, the IRS states the following concerning lump sum payouts:

 If death benefits are paid to you in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person’s death.

In terms of installment payouts, the IRS states the following in Publication 525:

 If you receive life insurance proceeds in installments, you can exclude part of each installment from your income. To determine the excluded part, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Include anything over this excluded part in your income as interest.

Example. The face amount of the policy is $75,000 and, as beneficiary, you choose to receive 120 monthly installments of $1,000 each. The excluded part of each installment is $625 ($75,000 ÷ 120), or $7,500 for an entire year. The rest of each payment, $375 a month (or $4,500 for an entire year), is interest income to you.

Although surviving spouses typically are exempt from taxes on life insurance proceeds, this may not always be the case. The IRS states the following on the subject:

 If your spouse died before October 23, 1986, and insurance proceeds paid to you because of the death of your spouse are received in installments, you can exclude up to $1,000 a year of the interest included in the installments. If you remarry, you can continue to take the exclusion.

Essentially, beneficiaries receiving proceeds in installments will likely earn interest income.

Life Insurance Proceeds and Estate Taxes

Unless the decedent used estate tax avoidance methods, life insurance policy values become part of the gross estate. Determining the value to include depends on the insured person. Accordingly, include all the proceeds if the owner insured their own life. Conversely, include only the cash value if the owner of the policy insured another person’s life. 

Transfers and Life Insurance Proceeds

Typically, transfers provide a way for policy owners to avoid the estate tax. In common estates, avoiding the estate tax is never a problem. However, other concerns for transfers on life insurance policies develop because of IRS regulation. These concerns include the following:

• The 3 Year Rule
• Gift Taxes
• Interest Income

The 3 Year Rule applies to transfers made without valuable consideration or a transfer to a trust. Basically, if the policy owner dies within three years of the policy transfer, the proceeds or cash value of the policy remains with the decedent’s gross estate.

Additionally, gift taxes apply if the policy owner transferred the policy to a beneficiary without consideration. If the present value of the life insurance policy exceeds the $15,000.00 annual exclusion for 2018, gift taxes result.

If the policy owner transfers the policy to a beneficiary for cash or other valuable consideration, the exclusion amount consists of the following: 

• The sum of the cash or consideration paid.
• Any additional premiums paid.
• Any other amounts paid.

Basically, if the life insurance proceeds received exceeds the amount paid into the policy, the IRS will tax the excess as interest income.

Conclusion

Among people with common estates, the assumption about life insurance proceeds are that they are tax free. Although I lack life insurance expertise, I know that life insurance proceeds are not always tax free and without complications. There are many types of life insurance policies on the market that work differently. Therefore, when deciding on a life insurance policy, buyers must understand how the policy works. This may require the help of a tax professional or an attorney if the buyer needs more than a simple life insurance policy. In the end, when it comes to life insurance, buyer beware.

Was this article helpful? Do you understand why life insurance proceeds are not always tax free? Share your comments or questions in the comment box below. 

Reference

IRS Publication 525, Taxable and Nontaxable Income – This IRS publication will provide you with all the information related to taxing life insurance proceeds including all the exceptions and exclusions. 

Learn How to Calculate the Value of Your Gross Estate, The Balance, by Julie Garber – This article explains the assets that make up your gross estate, including life insurance.