Laura Berry is a former State Farm insurance producer and insurance expert.

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Dan Walker graduated with a BS in Administrative Management in 2005 and has been working in his family’s insurance agency, FCI Agency, for 15 years. He is licensed as an agent to write property and casualty insurance, including home, auto, umbrella, and dwelling fire insurance. He’s also been featured on sites like Reviews.com.

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Reviewed by Daniel Walker
Licensed Car Insurance Agent

UPDATED: Nov 3, 2021

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money sitting on top of life insurance policy papers

Life insurance provides a death benefit upon the death of the insured to the policy owner’s chosen beneficiary or beneficiaries. That death benefit is often used for paying funeral expenses and providing an inheritance for the beneficiary.

If you’re the beneficiary of a life insurance policy, you may be wondering whether you’ll have to pay taxes on the death benefit. After all, no one wants to be hit with an unexpected tax bill, especially during a time of grieving.

And most life insurance policy owners probably don’t expect taxes to take a chunk out of the money they leave behind for their loved ones.

According to the IRS, benefits received as the result of the death of the insured generally aren’t included in taxable income.

Of course, there are some exceptions to this.

If your tax bill is bigger than you were expecting thanks to a life insurance payout, consider contacting the IRS about payment options or speaking to a tax relief company for help.

Whether you negotiate with the IRS on your own or through a third party, you may be eligible for an offer in compromise, an installment agreement, penalty abatement, or “currently not collectible” status. If the life insurance policy is still in place, you may still have options to reduce your tax liability by planning ahead.

Below are some situations that could result in a tax bill on a life insurance payout.

The Owner and the Insured Are Not the Same People

Life insurance policies involve three roles: the owner, the insured, and the beneficiary.

  • The Owner – the person responsible for paying the premiums on the policy and holds the power to make changes to the policy. They choose beneficiaries and change the length of the term.
  • The Insured – the person covered by the life insurance policy. Their death triggers the payout of the death benefit.
  • The Beneficiary – the person who receives the death benefit after the death of the insured person.

Usually, the owner and the insured are the same people, but that’s not always the case.

If someone takes out a life insurance policy on another person, and the beneficiary of the policy is a third person, the death benefit would be considered taxable income for the beneficiary.

If you’re the owner of the policy, you could avoid this issue by transferring ownership of the policy to the insured person. You’ll lose control of policy decisions and premium payments, but you’ll also save the beneficiary money they might have had to pay in taxes.

But keep in mind that you’ll need to plan ahead — this change needs to happen at least three years before the death of the insured for this to be a viable tax strategy.

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The Beneficiary Skips a Generation

If the death benefit goes to your spouse or child, it won’t be taxed. However, the generation-skipping transfer tax will apply for money that goes to beneficiaries who are, for instance, the grandchild of a donor.

The generation-skipping transfer tax exemption was $11,400 for 2019; transfers above that amount could be subject to a tax of up to 40 percent, according to IRS Form 709.

If you simply want the death benefit to go to someone who’s not your spouse or child, and assuming the benefit is more than $11,400, you may just have to live with the taxes the government will collect from it.

The Beneficiary Is the Insured’s Estate

Another instance where you may end up owing taxes on a death benefit is when the beneficiary is the insured’s estate rather than an individual. This only applies to estates of a certain size; the 2020 estate and gift tax exemption is $11.58 million per individual.

A person’s estate consists of all of a person’s assets minus any of their liabilities.

One reason a death benefit might go to an estate is that a specific beneficiary wasn’t named. In these cases, the fix is simply to change the beneficiary to an individual.

This can also happen by accident when the named beneficiary dies before the insured. To avoid that problem, simply name a contingent beneficiary, and be sure to keep your insurance company updated in case anything changes.

Another way to avoid the estate problem would be to use an irrevocable life insurance trust. An irrevocable life insurance trust keeps a life insurance policy from being included in a person’s estate.

Similar to transferring ownership of a life insurance policy to another individual, using an irrevocable life insurance trust means losing a certain amount of control over the policy — but it also comes with more certainty than giving the policy to someone else.

Keep in mind that the policy would have to be moved into the trust at least three years before the insured’s death.

The Policy Earns Interest

Any interest from the policy counts as taxable income. This consideration doesn’t apply to many policies — only those that the owner asks to be distributed in installments, or held to be distributed at a later date.

In those instances, the death benefit may accrue interest. The interest would count as taxable income, although the principal of the death benefit would still be tax-free.

If this is a concern, the owner of the policy can simply direct the insurance company to pay out the death benefit immediately and in one lump sum.

Author Bio:

Ashley Lee is a Content Strategist for Best Company specializing in debt relief, tax relief, and student debt. She’s been writing and editing professionally on topics such as finance and education for just under a decade.