Do I need to pay taxes on a life insurance payout?

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Do I need to pay taxes on a life insurance payout?

Life insurance policies name a designated beneficiary or beneficiaries to receive a payout, or death benefit, in the case of the policyholder’s death. The beneficiary will then file a claim with the life insurance company to receive their payout when the insured dies (here's how that works).

If you received a life insurance payout last year, you probably made more money in 2018 than you were expecting. You may be wondering how to handle that unexpected windfall when it comes to filing your tax returns. Here’s what you need to know.

Are life insurance payouts taxable?

According to the IRS, any money received from a life insurance policy is not required to be declared as gross income and does not need to be reported on your tax return. The money is typically distributed tax-free to the beneficiaries.

While life insurance payouts are not treated as taxable income, there are some scenarios where you will need to pay taxes on related funds.

Interest income

Any income earned in the form of interest is taxable and must be reported on your tax return.

Basically, "if the policyholder elected to hold payout for a period of time instead of paying it out immediately, you may have to pay taxes on the interest generated during that period of time," said Josh Zimmelman, owner of Westwood Tax & Consulting.

So if you received a delayed payout last year, any interest accrued before you recieved it is taxable. This may occur if the payout is held in an account, gaining interest, for a period of time before it's distributed to you.

Typically, death benefits are paid out in one lump sum to the beneficiary. However, a beneficiary may choose to receive incremental payouts over time — for example, if they would have difficulty managing a lump sum or they wish to receive stable, regular income. In that case, the payout will accrue interest over the years, which is taxable.

Estate tax

Sometimes, life insurance payouts are paid to the estate of the deceased, rather than directly to a beneficiary. This may occur if the policy’s beneficiary dies before they can receive the payout and there are no other beneficiaries. Here's a primer on what to do if your life insurance beneficiary dies before you.

“If the death benefit is paid to an estate (instead of to a person directly) then the person who later inherits that estate might have to pay estate taxes,” said Zimmelman.

When the payout is added to the estate, it may be subject to estate taxes (a tax on property transferred from a person to their heirs) or inheritance taxes (a tax on inheritances in six states) when transferred to the heir.

Also, payouts aren’t subject to income tax but they are considered part of your estate. If the payout you received last year puts your estate over the legal threshold, estate taxes would be paid from your estate in the event of your death.

Estate taxes only apply to wealthy estates — you can check the IRS estate tax limits to see if your estate would be affected. (Tip: the 2017 tax law made changes to the estate tax. Learn how that affects your life insurance options here.)

In most cases, life insurance payouts are not taxable, which is a huge benefit. Life insurance helps make sure your loved ones are taken care of in the event of your death. There are a lot of different options when it comes to life insurance - we can help you compare prices.

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Image: MARHARYTA MARKO