Most of us probably know the famous quote by Benjamin Franklin, which says, “In this world, nothing can be said to be certain except death and taxes.” While death insurance helps us to prepare for death, a lot of uncertainty surrounds the question of death insurance payout and taxes. Where do these two overlap? Is death insurance taxable?
You must have heard about the big money lottery winners that usually spend a huge chunk of their winnings paying taxes on their gain. As a designated beneficiary in a death insurance policy, you might be worried if the same thing will happen to you once you receive your death insurance payout.
In this post, we seek to address the question of whether or not death insurance is taxable. Our discussion will largely be informed by specific sections of the United States tax code. Read on to find out everything you need to know.
Is Death Insurance Taxable?
Before we dive deep into our discussion, let us address the main issue. Generally, life and death insurance benefit proceeds are tax-free. Whether you receive a lump sum or periodic payments, you will not pay any taxes on the proceeds as long as the amount doesn’t exceed the benefit specified in the policy document.
However, there are exceptions, and sometimes, your death benefit proceeds won’t get past the taxman. So, under what circumstances will the death benefit proceeds be subjected to taxation? Let us find out.
4 Types of Taxes That Can Make Your Death Insurance Taxable
Since a death insurance benefit isn’t considered an income, taxable income doesn’t apply. But there are four other types of taxes that death insurance policyholders and beneficiaries need to be aware of because they can be used to tax their death benefit. They are:
- Inheritance tax: This refers to a tax levied on inherited property, money, investments, or any other asset. Inheritance tax can range from 15-20%.
- Estate tax: The federal estate tax is usually applied to a high-value estate. As of 2020, the estate tax threshold is $11.58 million, up from $11.4 million in 2019. This means that any amount of your estate above the stated threshold is subject to taxation.
- Gift tax: This is a federal tax on all assets given out as gifts. The tax is in place to prevent people from avoiding the taxman by “gifting” money and other high-value assets to their loved ones instead of including them in their estate. Gift tax mostly comes into play when the policyholder is still alive and wants to transfer a policy to a beneficiary.
- Generation-skipping transfer tax: This is a tax applied when an inheritance is given to someone who is not the next immediate descendant. In this case, you are “skipping” someone to favor another. It doesn’t matter whether the person receiving the inheritance is family or not; the generation-skipping tax will still be applied. For instance, a grandmother would skip her son or daughter and leave an inheritance to her grandson/granddaughter.
So, When Is a Death Insurance Benefit Taxable?
Since you are now at ease, we want you to be aware of some specific instances when your death insurance benefit won’t get past the taxman.
1. When the amount you receive exceeds the policy amount
When a death insurance company pays a beneficiary a death benefit that is more than the stated amount, the extra amount of money you receive will be taxable. In most cases, the excess amount will be as a result of the interest earned on monthly premiums that were paid during the lifetime of the policy.
2. When three people are involved
Typically, there are only three roles in a death insurance policy: the owner of the policy, the insured, and the beneficiary. If there are only two people involved, the insurance is not taxable. For instance, if the owner is also the insured person, then there is no tax.
However, if a father (the owner of the policy) buys death insurance for his daughter (the insured), then names his son-in-law as the designated beneficiary, the payout is treated as taxable income for the son-in-law.
3. When you sell a death insurance policy
If you decide that you no longer need your death insurance and you want to sell it to an investment company, you need to keep in mind that the agent/broker selling the policy on your behalf will take a cut from the amount you receive.
Also, any amount you receive will automatically be treated as taxable income. And once you sell the policy, don’t expect your designated beneficiary to receive any death benefit upon your demise.
Generally, death insurance is not taxable. However, don’t make any assumption about which death insurance proceeds are taxable and which aren’t. Keep in mind that every situation is different and consider speaking to a tax advisor to be sure.
If you are in the market shopping for the best death insurance policy, be sure to contact Insurance Master today for guidance and affordable quotes!