Do you pay taxes on life insurance benefits?

Life insurance is typically taken out to provide a secure, guaranteed pool of funds for a loved one in the event of the policyholder’s death, often used to compensate for funeral expenses and loss of income. When the beneficiary files a claim, he or she might be emotionally distraught and in desperate need of income. The last thing they’re going to want to do is think about taxes. Fortunately, the death benefit from a life insurance policy is not taxable in the vast majority of cases. However, there are several possible exceptions to this rule:

Taxes on Accrued Interest

While many life insurance policies distribute death benefits in one lump sum, some distribute death benefits via a series of regular (most likely annual) installments to the beneficiary or beneficiaries. If the principal death benefit is $100,000, paid over 10 years at a rate of $10,000 per annum, the amount left with the life insurance company each year may accrue interest. In this case, the $100,000 principal would remain untaxed, but any growth from interest would be taxable.

The Estate Tax

Additionally, if the beneficiary is not locatable and/or deceased (see our article: What happens to the benefits for a life insurance policy when the beneficiary is deceased?), the death benefit will usually be added to the policyholder’s estate. In the rare event that the policyholder’s total estate value exceeds $5,430,000, the excess amount will be taxed. At the federal level, this tax will most likely be at a rate of 40%. For example, let’s say John named his wife Susan as beneficiary on his life insurance policy, but Susan passed away a year prior to John’s death. Now John is deceased, so the death benefit from his policy is added to his estate value. His estate (including the death benefit) is valued at $10 million, so he pays 40% of ($10,000,000-5,430,000), which results in a tax of $1,828,000. John’s relatives are left with an amount of $8,172,000.

Estates less than $5.43 million are not taxed by the federal government, but state-by-state estate taxes are highly variable. Some states may tax the benefit, any accrued interest, or some combination thereof. Reassuringly, most states do not tax the actual policy value.

These are unusual and highly specific circumstances, that do not affect the vast majority of life insurance payouts. However, just because your death benefit is safeguarded from federal taxes does not mean that it’s guaranteed. Life insurance companies will often find ways to delay or deny your claim, as they are financially motivated to hold onto your benefits. If you believe that your claim has been wrongfully denied, it’s in your best interest to contact an experienced life insurance lawyer.

 

 

 

 

NOTHING IN THIS POST SHOULD BE TAKEN AS LEGAL OR TAX ADVICE.  DO NOT RELY OR ACT ON THIS POST AS LEGAL OR TAX ADVICE. WE ARE NOT TAX LAWYERS.  IT IS INTENDED TO BE INFORMATIVE ONLY.  If you have further questions or would like legal advice, please feel free to contact The Boonswang Law Firm at (855) 865-4335.