In this day and age, it seems as though just about everything is taxable. Income is taxable (both in the form of wages and dividends). So are capital gains when selling capital assets. Then there are estate taxes and state inheritance taxes.
One exception to the above taxation involves proceeds from a life insurance policy. More often than not, a beneficiary might not be required to pay inheritance tax or any other kind of tax on the proceeds from such a policy.
The Purpose of Life Insurance
Why is this the case? Because life insurance doesn’t fall under the categories of investment or income-generating asset.
Specifically, life insurance is a contract between a policyholder and life insurance company. Basically, the policyholder agrees to pay a regular premium (generally monthly or quarterly) to the life insurance company. And the company, in turn, will provide a death benefit to the policyholder’s named beneficiaries.
Delving further into the dictionary, a death benefit represents a specific sum of money paid to beneficiaries of that life insurance policy, as long as the policyholder dies while the policy is still active. This means life insurance isn’t a capital investment. Rather, it’s in place to offer financial protection to dependents and beneficiaries if a policyholder dies. In some cases, it can help defray funeral expenses. In others, it can help with normal expenses.
And as a reminder, inheritance tax is:
- Levied only by a handful of states
- Based on the value of an inheritance received by the beneficiary
- Dependent on the beneficiary’s relationship to the policyholder (the more distant the relationship, the more likely the taxation)
As such, life insurance proceeds are generally not targeted for inheritance taxes.
The IRS Weighs In
The reason why the IRS generally takes a hands-off view when it comes to life insurance policies is because such proceeds aren’t categorized as gross or investment income. The monies don’t represent wages, salaries, or tips. Nor are they the result of any kind of asset dividends or gains.
But as is the case with other IRS issues, there are exceptions to the “no-taxes-on-life-insurance-proceeds” issue.
The issue becomes a little more complex if a beneficiary decides to accept the proceeds in installments, rather than a lump sum. In this situation, the benefit still isn’t taxable. But any interest accrued on that over-time payout is.
The complexity level is boosted further if the policyholder decides to name an estate, rather than an individual, as a beneficiary. Again, the proceeds themselves might not be taxed. But if that death benefit boosts the estate’s value to above $11,700,000 (in 2021) or $12,060,000 (in 2022), the estate tax could be triggered.
Not Taxable, But . . .
The nature and purpose of life insurance means that, in most cases, proceeds aren’t taxable. Beneficiaries can use those earnings in any way they like, without fear that part of them might be taken away. But as is the case with any lump sum, it’s a good idea to run information through a financial planner. This can help ensure that proceeds are used properly.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.