Death benefits paid out by an insurance policy are not considered part of the recipient's taxable income. However, there are instances in which the policy's recipient must pay taxes on the payout.
The recipient could have to pay taxes on the interest earned while the life insurance company kept the money if the policyholder decided to delay the distribution. 1 The beneficiary(s) of a death benefit may be responsible for paying estate taxes when they get the money.
How and When Is a Death Benefits Taxable?
Interest Earnings
Interest income is often subject to taxation at some time. Insurance has its limitations, and life insurance is no different. This implies that a recipient will have to pay taxes not on the total benefit but on the interest accrued since the policyholder's death before the beneficiary may access the funds.
Paying Taxes on an Estate or an Inheritance
Investors often need to make a better choice when they designate their estate as the beneficiary of their IRA, annuity, or life insurance policy.
However, the contractual benefit of designating a real person is lost, and the financial product is exposed to the probate procedure when the estate is named as the beneficiary. Adding assets to an estate's valuation might result in excessive estate taxes for a deceased person's beneficiaries.
Advice or Preventing Taxes on Your Life Insurance Payout
Tax Avoidance via Transfer of Ownership
Many estates will not be subject to federal estate tax. The basic exclusion level for a decedent's estate in 2022 is $12.06 million, while in 2023, it rises to $12.92 million. The highest marginal tax rate is 40%. 4
Life insurance payouts may or may not be included in the taxable estate of a decedent's estate, depending on the policy's ownership at the time of death. It is possible to avoid paying federal income tax on life insurance payouts by transferring ownership of the policy to another individual or business.
Transfer Tax
Since the insured and the policy owner are usually the same people, a gift tax may be incurred if there are three separate people named as the insured, the policy owner, and the beneficiary. Suppose the insured is not the same as the policyholder.
In that case, the IRS may consider the death benefit payment a gift from the policyholder to the beneficiary and subject the payment to the gift tax.
The gift tax is owed once you pass away, but your recipient won't have to pay it until the death benefit is more than $12.92 million. This includes annual contributions of more than $17,000.
Strategies for Tax Avoidance Involving Life Insurance Trusts
Setting up an irrevocable life insurance trust is another option for shielding insurance benefits from your taxable estate (ILIT). It is impossible to act as trustee of the trust or maintain the power to cancel the trust to complete the transfer of ownership.
Since the insurance is now in trust, you can no longer claim ownership. As a result, the money won't be counted for determining your estate. Why not just transfer the title to another person? You may still want some legal sway over the policy.
Rules Regarding Possession of a Life Insurance Policy
The Internal Revenue Service has established regulations to determine the beneficiary of a life insurance policy upon the insured's passing. Gifts of life insurance policies issued within three years of death are still liable to federal inheritance tax, according to the "three-year rule," the fundamental law governing rightful ownership in the financial industry.
This holds for the creation of an ILIT and the transfer of ownership to another person. The individual transferring the policy should expect an IRS investigation into any potential instances of ownership.
When a policy is transferred, the original owner loses the ability to change the policy's beneficiaries, borrow against it, surrender it, cancel it, or choose the beneficiaries who will receive payments.
Summary
People typically carry life insurance policies with death payouts ranging from half a million to several million dollars. You could be shocked at the total amount of your estate if you factor in the worth of your home, retirement funds, savings, and other possessions.
Some people may have an estate tax problem if they have accumulated significant wealth over many years. You may solve this problem by making the most of your giving abilities and transferring insurance ownership whenever possible at little or no gift-tax expense.
If you outlive the three-year transfer period, your heirs may be able to avoid paying taxes on a sizeable portion of your assets.
