This information is intended for educational purposes only and should not be considered tax advice. Please consult a qualified tax professional
As a cornerstone of financial planning for more than half of Americans, life insurance offers a sense of security, allowing policy owners to rest assured that their loved ones will be cared for in their absence. While life insurance is often considered a tax-free safety net, improper structuring can lead to unexpected taxes for your beneficiaries.
If you previously purchased coverage or are thinking of getting more, you might wonder if your beneficiaries have to pay taxes on inheritance from life insurance. In many cases, the answer is no. However, specific circumstances may involve taxes and potentially lessen the financial security you intend to provide.
Here’s a closer look at when beneficiaries have to pay taxes on life insurance and how you can reduce their obligation.
3 Reasons Beneficiaries Have to Pay Taxes on Inheritance from Life Insurance
The IRS typically doesn’t consider life insurance death benefits as taxable income, but beneficiaries may owe taxes in three scenarios.
1. The Beneficiary Earns Interest on the Insurance Death Benefit
Beneficiaries can avoid paying taxes if they receive the death benefit as a lump sum. However, some prefer to convert it into a payment stream, such as with a guaranteed life income annuity. In this instance, the beneficiary pays taxes on the interest accrued or the amount that exceeds the original death benefit. Even though the principal death benefit amount isn’t taxed, interest earnings or capital appreciation are taxable.
When Are Taxes Due?
If the beneficiary earns interest on the distribution, income taxes are due when they file their annual income tax return. Generally, beneficiaries report the taxable amount based on the income document they receive, such as Form 1099-R or 1099-INT.
2. The Insurance Death Benefit Is Paid to an Estate and Exceeds Threshold Limits
If an insurance policy’s death benefit is paid to an estate and exceeds the tax exemption amount, it may be subject to state and federal estate taxes.
- In 2024, the federal exemption amount for individuals increased from $12.92 million to $13.61 million. The exemption amount for married couples is $27.22 million.
- In addition to Washington, DC, 12 states currently impose an estate tax.
When Are Taxes Due?
If estate taxes are due on the distribution, the estate tax return Form 706 is usually due nine months after the insured’s death. However, the estate executor may request an extension of up to six months.
3. The Owner and Insured Are Different People
Also known as “the Goodman Triangle,” it’s possible to set up a life insurance policy where the policy owner, the insured, and the beneficiary are different people. When the policy owner differs from the insured, the payout to the beneficiary may be considered a taxable gift.
Here’s a hypothetical example to help illustrate: John buys a life insurance policy for his wife, Sherry, and names their son, Luke, as the beneficiary. If Sherry passes away and Luke receives the life insurance inheritance, the IRS will consider it a taxable gift from John because John was the policyholder.
When Are Taxes Due?
In this example, even though Luke received the proceeds as the beneficiary, John, the policyholder, may have to pay gift taxes for any amount that exceeds federal gift tax exemption limits. Accordingly, John must file IRS Form 709 by the following year’s tax filing deadline.
Tips to Help Beneficiaries Avoid Paying Taxes on Life Insurance
Implementing the following strategies may help your beneficiaries reduce or avoid tax liabilities, ensuring they receive your life insurance policy’s full benefit.
Educate Your Beneficiaries on Proper Financial Planning
One of the surest ways for beneficiaries to avoid taxes is by taking the payout as a lump sum instead of leaving it in an account that accrues interest. Encourage your loved ones to work with an experienced financial planner who can guide them through the process. Knowledge and proper planning can empower your beneficiaries and offer more control over their financial future.
Name Direct Beneficiaries Instead of Your Estate
As you choose your beneficiaries, naming individuals directly—such as your spouse, children, or loved ones—instead of your estate can help mitigate potential taxes on distributions. By doing this, you can prevent the death benefit from being included in your estate, which may be subject to state and federal taxes.
Consider Using an Irrevocable Life Trust
If you don’t want to name an individual as the beneficiary of your life insurance, consider forming an irrevocable life insurance trust. In this case, the trust owns the policy, so the proceeds aren’t included in your estate, helping avoid estate taxes.
Monitor Your Estate Size
If you name your estate as the beneficiary, monitoring its size is critical to ensure you stay within exemption limits. Consider gifting assets or using other estate tax planning methods during your lifetime to reduce your estate’s size if it’s nearing state or federal limits.
Stay Out of the Goodman Triangle
Avoiding the Goodman Triangle starts and ends with ensuring the policy owner, insured, and beneficiary are aligned correctly to prevent the payout from being considered a taxable gift. To prevent the Goodman Triangle, ensure the policy owner and insured are the same person or that the policy owner and beneficiary are the same person.
Minimizing Unintended Outcomes for Your Beneficiaries
When leaving your loved ones an inheritance, even the best intentions can lead to unintended consequences, such as heavy taxation. To minimize the likelihood of unintended outcomes, consider working with an experienced financial professional. A Bankers Life representative can offer a personalized look at your situation and provide guidance, helping to instill more confidence in your financial planning decisions.
Contact Bankers Life today for help making informed decisions about your life insurance and securing the future for those who matter most to you.
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Insurers and their representatives are not permitted by law to offer tax or legal advice. The general and educational information here supports the sales, marketing or service of insurance policies. Based upon individuals’ particular circumstances and objectives, they should seek specific advice from their own qualified and duly-licensed independent tax or legal advisors.
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This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
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