Do I Have to Pay Taxes on My Life insurance Death Benefit?

Life insurance is a lifesaver for loved ones you leave behind. But there can be some scary surprises if you aren’t familiar with the tax codes attached to your policy.

If your life insurance policy is simple, your payout is simple and tax-free. A death benefit is not considered income.

However, if your policy is set up to gain interest, any interest you earn on your policy is considered income and therefore is taxable.

Simple Term Policies: No Tax

A term life insurance policy,  is non-taxable. You buy the policy for say $50,000 and your loved ones will receive $50,000 tax-free.

Keep in mind that you must appoint a beneficiary. Not having one may delay your benefit from getting to your loved ones as it makes its way through probate court.

Also, consider leaving your benefit to more than one beneficiary to ensure that if one dies, the surviving one will receive the payout, not the IRS.

If you want your child to be your beneficiary, set up a trust. This ensures that inheritance is used in a responsible way.

Permanent Policies: Probably Taxed

The federal government and some state governments handle permanent life insurance differently since this type of policy can accrue interest. Beneficiaries may have to pay taxes on that gained interest.

However, the interest is taxable only if it exceeds the amount you paid in premiums. And it’s not retroactive. Your loved ones only pay on the interest earned after your death.

Now if you borrowed against your policy for more than you’ve paid in premiums and the interest it earned, you must pay what you owe before you die or your loved ones will pay taxes on the benefit. They’re also considered taxable income.

Useful Tax Strategies

Strategy #1: Transfer Your Life Insurance Policy

Transferring your policy gets you off the hook for taxes as well as premium payments. And while the person to whom you transfer is responsible for the payments and taxes, you can set aside a part of the benefit as a gift to help them pay those expenses. A gift is tax-free.

Transfers are irrevocable, so choose your transferee carefully. You can transfer your policy to a trust, which is especially helpful if your child is your beneficiary.

Now, the IRS does have some caveats regarding transfers.

And if you sell your policy, while this also frees you from paying your monthly premiums, you are on the hook for any cash or profits you received above the amount you paid in premiums.

Strategy #2: Tie Your Policy to an Estate

This is a great strategy if you make less than $12 million as an individual or $24 million as a couple. That’s the current federal threshold. If you make more than that, the estate is taxable. If you earn less than the threshold, the estate is tax-free. But no matter what side of the threshold you’re on, you do have to report the payout to the IRS.

Is your brain spinning yet? This is a lot of information—much of it beyond the scope of one humble post. Taxes, like people, can be complicated.

Make sure you talk to an attorney, tax professional, or accountant before making any tax-related decisions and putting them in writing. Your loved ones will thank you