Income Tax on Life Insurance Benefits and Annuities

Taxes and insurance can require some careful balancing.

Taxes and insurance can require some careful balancing.

Estate tax filings have steadily declined since the early 2000s, according to IRS statistics, and lawmakers looking to solve the nation's budget crisis are looking to inheritance as one way of increasing tax revenue. Life insurance benefits are intended to be tax-free income for the bereaved, but that can change based on how you structure your insurance and your estate.

Benefits vs. Estate

In most cases, the death benefit from life insurance is not taxable, but the contents of the deceased's estate are taxable. This is because life insurance benefits are intended to protect a family from the financial hardship associated with burial expenses and losing a breadwinner, while inheritance is more akin to "bonus" money from an employer. If a life insurance policy lists an individual as beneficiary, that person gets the benefits tax-free. If it lists the estate as beneficiary, the estate receives the benefit tax-free, but the money is taxed as part of the estate when transferred to an inheritor.

Annuities

When most people think of life insurance, they think of a single lump-sum payment made soon after the insured dies. An annuity is an arrangement made with the insurance company to instead pay out the benefit periodically over time. This creates a long-term income stream for the beneficiary, and interest is earned on the portion of the death benefit that has not yet been paid out.

Annuities and Taxation

The proceeds from life insurance remain tax-free when paid as an annuity. However, the principal in an annuity account also earns interest. That interest is considered a capital gain. Each payment you receive will consist of a portion from the original benefit and a portion that represents taxable interest. You or your accountant will receive a statement at the end of each year defining what portion of that income is taxable for that year.

Secondary Annuities

If the estate was the beneficiary of the life insurance, you can have the death benefit pay-off as an annuity for all the reasons you would if it went directly to an individual. In that case, the entire amount of each annuity payment would be taxable as income, since it comes from the taxable estate rather than the tax-free death benefit.

Common Sense Caution

These rules are generally true of federal tax laws and in most states. However, insurance and tax law are both complex and hold potentially crippling repercussions for even honest mistakes. Consult a tax or insurance professional before making a final decision about structuring your estate or spending money with the assumption it will be free from taxation.

References

About the Author

Jake Wayne has written professionally for more than 12 years, including assignments in business writing, national magazines and book-length projects. He has a psychology degree from the University of Oregon and black belts in three martial arts.

Photo Credits

  • Comstock Images/Comstock/Getty Images