They say death and taxes are both inevitable, and sometimes they show up together. Death benefits come in a variety of flavors. Depending on the type of benefit you receive, you may end up paying tax on some or all of the money. Life insurance benefits are usually tax free, but not always.
If your spouse or parent, say, bought a $150,000 life insurance policy and you receive $150,000 when he dies, there's no tax. Some policies that earn interest on the premiums pay you more than the face value. For instance, if you got $170,000 from the policy, you have to pay income tax on the extra $20,000. IRS Publication 525 has the formula for figuring the tax if the insurer pays you in installments.
If the deceased leaves enough assets behind to pay estate tax -- as of 2013, the estate has to be worth more than $5.25 million -- the proceeds from any life insurance she owns are part of the estate. A $200,000 policy, for instance, adds $200,000 to the amount subject to the estate tax. You, as the beneficiary, don't have to pay the tax, but if you're in the will the tax can eat into the estate and your inheritance. If someone else owns the policy, there's no tax.
Pension and Annuity
Pensions and annuities often include some sort of death benefit. These are often, but not always, taxable. When you get a lump-sum death benefit from a variable annuity, for instance, any part greater than the cost of the contract to the deceased is taxable. Death benefits from pension funds are generally taxable. Many plans provide information about taxes on their website, so you can research whether your particular death benefit is vulnerable.
When someone dies, his employer may have an obligation to pay survivor benefits. If you're the survivor, whatever benefits you receive are probably taxable. These may include accrued salary, the deceased's portion of profit sharing or stock bonuses or money from a pension plan. Usually you treat these according to the type of income -- accrued salary gets taxed as income, just like regular income. If you receive a payout from an employer life-insurance policy, that's treated like any other life insurance payment.
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