When a person is drawing up their life insurance, one of the most frequently asked questions is whether the beneficiary will have to pay taxes on death benefits or payout. This is an obvious question “Do you have to pay taxes on life insurance?” and if tax is applicable there is no way to avoid it. It is understandable that paying taxes on life insurance death benefits can be quite annoying and actually significantly cut into the sum of the total benefit that is given.
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However, it is not always the case that a beneficiary has to pay taxes on life insurance payouts. In fact, in many cases they can receive the full amount without having to pay in regard to taxes.
When You Have to Pay Taxes on Life Insurance?
The times that you have to pay for taxes on life insurance money are relatively rare, but they will depend on the policy and how you became a beneficiary in the first place.
Interest: Any interest that is earned by the policy and paid to you as part of the benefit is taxable. This is because the interest was accrued by means outside the already taxed money that was paid by the owner of the policy.
Transfer: If the policy was transferred to you for cash or other considerations, then the tax-free status are only limited to the money that you paid to acquire the policy plus any additional premiums that you have paid into the policy. For example, let’s say you paid $5,000 for a life insurance policy that offered $50,000 in benefits. Before the policy fully matured, you paid an additional $5,000 in terms of premiums. According to the law, $40,000 of the benefits is taxable with the $10,000 being paid into the policy non-taxable because taxes were already paid on the income.
Installments: This is an example of having to pay taxes on life insurance benefits when the installments received also include interest that has built up over time. For example, if the beneficiary chooses to receive the benefits in monthly installments over time, then whatever interest had built up during the policy will be included in the payouts. So, instead of a lump sum where the beneficiary would pay taxes on the payouts at once, they would be subject to whatever interest was paid in the calendar year.
In some cases, this would result in actually paying less per year than if the benefits were all received at once, but in most circumstances it is generally better to receive the benefit in one sum to reduce the total applicable taxes to a single year.
Lifetime Installments: This is a more unusual policy in which the beneficiary receives installments over their lifetime regardless of how long they live. The taxable amount would be determined by the interest that was garnered in the sum and was paid to the beneficiary.
Employer Owned Life Insurance: Here, the policyholder is the company itself which may include more interest in terms of the benefits that were paid into the policy. For the policyholder, the income of any proceeds received which are more than the premiums or other amounts paid on the policy are subject to taxes. However, there are exceptions to those who pay taxes on life insurance money.
- Previous to the policy being issued, a written notice about the insurance between the employer and employee gives consent about either the employee being under the hire of the employer for a full year or the amount is paid to the designated beneficiary of the employee, namely the spouse.
Under these specific circumstances, the entire benefit is non-taxable.
Policy for Cash: If the life insurance policy is surrendered for cash, then you must include any income that was more than the cost of the policy itself. In most cases, the premiums you paid will not be included as taxable. This may also include any dividends, rebates or an un-repaid loan that was not included in your policy.
There are certain forms that you may have to fill out when you pay taxes on life insurance benefits. You will want to check with the IRS and use forms such as 1099-R to report any taxable part of the benefits that were received. In this case, you will want to check with the appropriate authorities or experts who can offer the right advice given your specific situation.
For many beneficiaries, they may not be fully aware of what is taxable or not under the benefits they receive from the policy itself. It is best in these circumstances to check out all aspects of the policy to ensure that everything is properly covered.
When Life Insurance is Tax Free?
A beneficiary does not have to pay taxes on life insurance benefits according to the IRS under most conditions. There are certain exceptions that have already been listed, but for the most part people who receive a payout will not have it subject to taxes.
There are a couple of reasons for this as listed by the IRS. The person who paid into the policy has already paid taxes on the money they earned. And, the person who paid the money on the premiums has passed away and is no longer subject to taxation on money that was placed in a life insurance policy. While their estate may be taxed when transferred for example, the premiums that they paid into a life insurance policy is not subject to that type of taxation.
Basically, this means that if you only receive the stated death benefits with no interest that was added, then you do not have to report the benefits as income. For those who to avoid paying taxes on life insurance death benefits, it would be advisable to work with the owner of the policy and the insurance company to ensure that it follows the tax law so that no taxation will occur.
Understanding when you may or may not have to pay on any benefits that you receive through a life insurance policy can help shape your taxes for the year or over the time the benefits are received.