DO BENEFICIARIES PAY TAX ON LIFE INSURANCE?
When purchasing life insurance for the first time, many questions arise, including whether or not life insurance is taxed. The short answer is usually not. Beneficiaries are generally exempt from paying taxes on life insurance proceeds. Beneficiaries do not have to report the payout as income, so it is a tax-free lump sum that they can spend as they wish.
However, there are some occasions when your beneficiaries will have to pay taxes. Let's talk about these scenarios, how to avoid them and how life insurance payouts work.
WHAT IS A LIFE INSURANCE BENEFICIARY?
A person or persons, or an entity, named as the recipient of a policy's death benefit is referred to as a life insurance beneficiary. A beneficiary can be your spouse, a dependent, a parent, or anyone else you want. A charitable organization, a church, or an educational institution can also be designated as a beneficiary. You can also name your estate as the beneficiary of the policy.
Beneficiaries can be designated in a variety of ways. You can name multiple beneficiaries to share the payout and assign an amount or percentage of the death benefit to each. You could also name primary and contingent beneficiaries as backup beneficiaries.
HOW DO LIFE INSURANCE PAYOUTS WORK?
Most life insurance policies, including level term and decreasing term life insurance, will pay out a lump sum. Other types, such as family income benefits, will provide a consistent income until the end of the policy term. It is critical to consider what your loved ones would benefit the most from.
The payout is the result of a successful claim on a valid policy, and it can be used for several purposes. For example, your family could use the funds to pay off the mortgage, childcare fees, household bills, and day-to-day living expenses.
WHEN DO BENEFICIARIES PAY TAXES ON LIFE INSURANCE?
1. There Is a Policy Transfer
If you transfer ownership of your life insurance policy to another party before you die, the income tax exclusion for death benefit proceeds may be limited to the amount paid by the new owner. In other words, the beneficiary may consider some or all of the proceeds taxable income. This is a complicated situation, and you should consult with a tax professional before proceeding to assess the potential consequences.
2. There Is Interest On Accumulated Death Benefits
Interest income is almost always subject to taxation at some point. Life insurance is no different. This means that if a beneficiary receives life insurance proceeds after a period of interest accumulation rather than immediately upon the policyholder's death, the beneficiary must pay taxes on the interest rather than the full benefit. The principal portion of the payment is tax-free though.
3. The Estate Is Beneficiary
One common mistake that investors seem to make is naming "payable to my estate" as the beneficiary of a contractual agreement, such as an IRA, an annuity, or a life insurance policy. However, naming the estate as your beneficiary eliminates the contractual benefit of naming a real person and subjects the financial product to the probate process. Leaving items to your estate increases the value of the estate and may subject your heirs to extremely high estate taxes.
HOW DO I MAKE SURE MY LIFE INSURANCE BENEFICIARY DOES NOT PAY TAX?
1. Name At least One Primary And Contingent Beneficiary
Because a policy payout may be taxable if it goes to your estate, you should name multiple beneficiaries. By including at least one primary and contingent beneficiary, the chances are good that someone will be around to take advantage of the policy's tax-free benefit.
2. Notify Your Beneficiaries
It's amazing how many life insurance benefits go unclaimed simply because people are unaware they've been named a beneficiary! When you name a beneficiary, notify them and provide their contact information to your insurance company so they can easily file a claim if you die.
3. Inform Beneficiaries Of The Tax Benefits Of A Lump Sum Payout
Unless you specify otherwise, the beneficiary can choose whether they want the payment as a lump sum, interest option, annuity option, or something else. Beneficiaries who take the benefit as a lump sum will receive a single payment to use however they see fit, whether to replace income, pay off debt, or cover a mortgage. Other options, such as interest and annuities, may result in interest income being taxed.
Life insurance is a way for you to help financially protect your loved ones after you die. A beneficiary would have to report and pay taxes on any interest earned or taxable gains made from the life insurance proceeds after receiving the money. The simplest way to help them avoid paying taxes on your life insurance payout is to name them as beneficiaries rather than your estate.
However, if your financial situation is complicated or your estate may be subject to estate taxes, you should probably consult a financial adviser or tax professional who can advise you on ways to minimize the tax impact.
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