Most insurance benefits, such as benefit payments on homeowner or auto insurance, are considered reimbursements and are nontaxable. In general, life insurance benefits are also federally nontaxable. In some circumstances, however, when the benefit exceeds a threshold, federal or state taxes may be due. Whole life insurance policy payouts may or may not be taxable, depending upon the category of the payout.
Nontaxable Life Insurance Benefits
If you are the beneficiary of a life insurance policy, you owe no federal or state taxes on the death benefit, according to financial planner Drew Tignanelli. While a few states have a tax on inheritances, they either exempt entirely money received from the deceased's life insurance or exempt amounts below a relatively high threshold. In Maryland, for example, taxes are due on benefits exceeding $1 million. While the federal government has no inheritance tax, it does have a tax on estates that exceed a threshold amount. For 2013, the threshold is $5.25 million. Under most circumstances, the portion of a life insurance benefit that exceeds $5.25 million is subject to federal taxation.
Paid-Up Life Policies
If you buy a whole life policy and pay the premiums, at some point in your life the policy will likely be paid up. A few insurance companies have what they call "limited whole life," where the payouts during your lifetime are smaller, but the policy can be paid up in as little as 10 years. With such a policy, you could conceivably be paid up by the time you're 30. With paid up whole life policies you may receive dividends, interest on your contributions or both. Dividends are nontaxable. They're considered the return of your premiums, according to CPA Gregory Burke. Interest, however, is taxable, but the taxes would be on periodic payments received during your lifetime and unrelated to a beneficiary life insurance check.
If a rich uncle dies in 2013 and his $6 million life insurance names you as the beneficiary, federal estate taxes are due. Assuming he did not also include you in his will -- and because for 2013 $5.25 million is exempt -- you'll owe taxes on $750,000. The federal estate tax rate is 40 percent. Therefore, you should withhold $300,000.
In the unlikely event that you, not your rich uncle, paid the premiums on his life insurance policy, no taxes are due on death benefits from the policy that exceed the threshold where estate taxes ordinarily become due. If a third party paid the premiums, you would also have no estate taxes on any death benefits.