Do Beneficiaries Pay Taxes On Life Insurance Policy? It Can Be No And Yes

Beneficiaries are appointed or mentioned heirs by a policyholder in a life insurance contract to receive a death benefit when he or she (policyholder) dies in the period. They legally receive it both lump sum and monthly depending on the life policy type purchased. Do beneficiaries pay taxes on life insurance policies?

This case often becomes the first question when they know they are one of the mentioned beneficiaries. Normally, the beneficiaries have no obligation to pay taxes but it might be a few exceptions based on the life insurance type or the insurer. Let’s dive in for more understanding!



What Is Beneficiary And Death Benefit?

A life insurance beneficiary is a mentioned person or persons in the policyholder’s contract. The function of the beneficiary is to receive a death benefit when the policyholder dies during the term.

Policyholders may take one or more beneficiaries such as their spouse, children, grandchildren, parents, friends, and even their business partners. If you give more than one beneficiary, another is called a contingent beneficiary. The contingent beneficiary will receive the full death benefit if the first beneficiary passes away before the policyholder.

Do beneficiaries pay takes on life insurance policies? Before knowing the answer, let’s understand what the death benefit is. The death benefit is the amount of money payable to mentioned beneficiary or beneficiaries.

Beneficiaries receive the death benefit after the policyholder dies and he or she is still involved in the contract. It can be said that the benefit will be given as long as the policy has a good reputation. According to the types of policy, the amount of the death benefit may vary from a few thousand dollars to more than $1 million.

Certainly, it is tax-exempt and they can receive it in one lump sum or over time. Even though, it may earn interest and is subject to tax.


Exceptions To Death Benefit Taxes

Once more, beneficiaries do not need to pay taxes as most life insurance policies earn a tax-free death benefit. Later on, the coverage can be used to cover some expenses costs such as funeral costs, debt payoff, children’s college fees, home rent, and medical bills, until income replacement. Even, some insurers provide life insurance claims for retirement.

Beneficiaries do not need to report a life insurance payout as income in their tax return. Even though, some exceptions below should be concern properly:


Interest Taxes

Your beneficiary may have to pay tax or report the interest received to the tax return if the life insurance earns interest. This case also occurs when the death benefit is paid out as an installment, not a lump sum. The interest is subject to income tax and you should report any interest from the remaining balance held by the insurance company.

Do beneficiaries pay taxes on life insurance policies? No, they don’t but this exception contains the income interest with the following calculation. If beneficiaries receive a $500,000 death benefit and it earns 10% interest for one year before being paid out, they have to pay taxes on the $50,000 growth.


Gift Taxes

Gift taxes exist when someone buys a life insurance plan for his or her spouse but the mentioned beneficiaries are their children. When the spouse dies during the period, the death benefit is given to the children, not the policyholder. The death benefit, then, is considered a gift based on IRS and it may be a gift tax.


Buy An Existing Policy

What does it mean with purchasing an existing policy? For instance, you purchase a policy for $10,000 with a death benefit of $100,000. Later on, you pay $30,000 in premiums where it earns taxes of $60,000. It is calculated from $100,000 deducted from the $40,000 for the purchase price and premiums.


Estate And Inheritance Taxes

The taxable death benefit can occur when the applicants do not use people as their beneficiaries but the estate. Some insurers allow them to write their estate as their beneficiaries in their plan contract. Of course, this case includes one poor decision often do by investors.

Using estate as your beneficiary, indeed, can give the contractual advantage but leaving items to your estate also increases the estate’s value. Surely, it may subject your heirs to exceptionally high estate taxes. So, the answer “Do beneficiaries pay taxes on life insurance policies? “in this case is yes.

Moreover, Section 2042 of the Internal Revenue Code informs on the value of life insurance proceeds included in your gross estate. It includes:

  • Estate is paid either directly or indirectly.
  • It is for named beneficiaries if your policy has “incidents of ownership” at the time of your death.


Do Policyholders Pay Tax On Their Life Insurance Policy?

Besides beneficiaries, policyholders also have no obligation to pay tax as the death benefit is tax-free. It is applied for term life and permanent life policies but these coverage plans keep having exceptions to know. When do the policyholders pay their taxes?


Surrender Permanent Life Policies

Insurers will not ask for tax when paying your death benefit to your beneficiaries. It is no matter the coverage plans both universal life and whole life policies have a cash value component.

However, the policyholders may owe taxes if they surrender their policy and take the cash value out. It will happen when the contributed premiums are deducted from all dividends received or it exceeds the cash value.


Dividend Exceeds Premiums Paid

All policies may pay an annual dividend and normally it does not take tax or tax-free. Policyholders have to pay tax when the dividends exceed the premiums paid.


Loan Exceeds The Total Premiums

Generally, your policy does not ask for paying tax when you take out a loan against your policy. You should pay taxes when your loan value exceeds the total premiums you paid.

For example, you purchase a whole life insurance policy with total premiums of $50,000. Further, you take a loan out for $60,000 from your policy and it may take you to pay taxes of $10,000 if the policy lapses.


Part Of The Estate

Lastly, the death benefit becomes taxable if the life insurance includes part of the estate. The estate will owe tax when the policyholder asset’s value exceeds 11.70 million in 2021 or $12.06 million in 2022.


Two Ways Avoiding Taxation

Do beneficiaries pay takes on life insurance policies or could be avoided? The fact is those taxes can be avoided in two ways such as using life insurance trusts and using an ownership transfer.


Using Life Insurance Trusts

Creating an irrevocable life insurance trust (ILIT) includes one of the most effective ways to remove life insurance proceeds from your taxable estate. You have to find a life insurance trust to be your trustee to complete your ownership transfer.

In this case, you not only cannot be the trustee but also revoke the trust. Due to you are not the owner again the proceeds are not included as part of your estate and the policy is held in trust.

What is the reason to use the life insurance trust? Here is the list to know:

  • Maintain some legal control over the policy.
  • There is a risk of the individual owners may fail to pay premiums.
  • Ensure all premiums are paid promptly.
  • The life insurance trust can handle the money or death benefit for the children when they are your beneficiaries. But, it should come from the minor kids from your previous marriage. You can take your family member as a trustee and handle their money under the trust document terms.


Using An Ownership Transfer

Secondly, you can avoid your estate tax by involving an ownership transfer. Truthfully, the taxable estates in the life insurance rely on the policy owner when the insured dies at the time. You surely can avoid federal taxation by transferring ownership of your policy to another person or entity.

Well, it is a few guidelines to consider an ownership transfer:

Choose A New Competent Owner

Do beneficiaries pay taxes on life insurance policies? It can be if they are included as heirs for estate beneficiaries. They should choose a competent entity or adult as their new owner. Afterward, call the insurance company to release the proper assignment, or transfer of ownership, forms.

New Owner Gift

Later on, you can give a gift to your new owners as they will pay the premiums on your policy. In 2021, people typically gift up to $15,000 per person and in 2022 it increases to  $16,000 per person. Surely, the gift is useful to pay premiums.

Give Up All Rights

The policyholders will give up all rights as they need to make change their policy in the future. They may request the new owners to change it if they are your family members, children, or mentioned friends.

Beware Of Divorce

Ownership transfer is an irrevocable moment and you have to be careful when meeting a divorce situation if you want to name your new owner.

Written Confirmation

Lastly, you have to obtain written confirmation to prove the ownership change from your insurance company.


How To File Life Insurance Claim

After answering the question of do beneficiaries pay taxes on life insurance policies, it emerges a new question. When do they (beneficiaries) file claims? The beneficiaries can file the claims whenever they want or need it as the life insurer never limits the time.

However, they should file their life insurance claim as early as they can. This case helps to ensure your claim process runs faster. Generally, the filing claim process needs 2 weeks to 2 months.

How to file a claim for life insurance is available below:

  • Call the policyholder’s insurance agent or go to the office directly.
  • Request a claim form and fill it with some information. Typically, it needs a deceased death certificate, policy number, social security number, date of birth and death, and place of death.

After submitting the claim, follow the progress from the insurance company’s online portal. Decide how to receive the benefits when approved. Beneficiaries can receive it such as a lump sum, annuity, installment, a check, or direct deposit.


Taxable Death Benefit For Policyholders

In life insurance, beneficiaries are the party who benefits the most as they receive death benefits without paying tax. The policyholder should have a beneficiary and include it in the contract. If the life insurance policy is purchased without beneficiaries, it will be so harmful.

Without beneficiaries, the death benefits or the proceeds go to the deceased’s estate. It implies that the claim will be added to the value of the assets and could be subject to the federal estate tax.


Final Words

Do beneficiaries pay taxes on life insurance policies? The answer is typically no as they are just recipients but some exceptions or situations force them to pay taxes. Nonetheless, it can be avoided by using a life insurance trust or using an ownership transfer.

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