11.18 How Life Insurance Proceeds Are Taxed to a Beneficiary

Life insurance proceeds received upon the death of the insured are generally tax free. However, insurance proceeds may be subject to estate tax so that the beneficiary actually receives a reduced amount (39.8). Interest paid on proceeds left with the insurer is taxable.

Read the following checklist to find how your insurance receipts are taxed—

A lump-sum payment of the full face value of a life insurance policy: The proceeds are generally tax free.

The tax-free exclusion also covers death benefit payments made under endowment contracts, workers’ compensation insurance contracts, employers’ group insurance plans, or accident and health insurance contracts.

Insurance proceeds may be taxable where the policy was transferred for valuable consideration. Exceptions to this rule are made for transfers among partners and corporations and their stockholders and officers.

Installment payments spread over your life under a policy that could have been paid in a lump sum:

Part of each installment attributed to interest may be taxed. Divide the face amount of the policy by the number of years the installments are to be paid. The result is the amount that is received tax free each year.

If the policy guarantees payments to a secondary beneficiary if you should die before receiving a specified number of payments, the tax-free amount is reduced by the present value of the secondary beneficiary’s interest in the policy. The insurance company can give you this figure.

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image Planning Reminder
Accelerated Death Benefits
A person who is terminally ill may withdraw without tax life insurance proceeds to pay medical bills and other living expenses. For policies lacking an accelerated benefits clause, it is possible to sell a life insurance policy without incurring tax to a viatical settlement company (17.16).
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Installment payments for a fixed number of years under a policy that could have been paid in a lump sum.

Divide the full face amount of the policy by the number of years you are to receive the installments. The result is the amount that is received tax free each year.

EXAMPLE
Fran is the beneficiary of her husband’s $100,000 life insurance policy. She elects to take installment payments for 10 years. Each year she may receive tax-free principal of $10,000 ($100,000 ÷ 10).

Installment payments when there is no lump-sum option in the policy:

You must find the discounted value of the policy at the date of the insured’s death and use that as the principal amount. The insurance company can give you that figure. After you find the discounted value, you divide it by the number of years you are to receive installments. The result is the amount that is tax free. The remainder is taxed.

EXAMPLE
Under an insurance policy of an insured man who died in 2012,, his surviving spouse is entitled to $5,000 a year for life. Her life expectancy is 20 years. There is no lump sum stated in the policy. Say the discounted value of the wife’s rights is $60,000. The principal amount spread to each year for the wife is $3,000 ($60,000 ÷ 20). Subtracting $3,000 from each annual $5,000 payment gives her taxable income of $2,000.

Payments to you along with other beneficiaries under the same policy, by lump-sum or varying installments.

See the following Example for the way multiple beneficiaries may be taxed.

EXAMPLE
Under a life insurance policy of an insured man who died in 2012, a surviving wife, daughter, and nephew are all beneficiaries. The wife is entitled to a lump sum of $60,000. The daughter and nephew are each entitled to a lump sum of $35,000. Under the installment options, the wife chooses to receive $5,000 a year for the rest of her life. (She has a 20-year life expectancy.) The daughter and the nephew each choose a yearly payment of $5,000 for 10 years. This is how each yearly installment is taxed:
Wife: The principal amount spread to each year is $3,000 ($60,000 ÷ 20-year life expectancy). Subtracting $3,000 from the yearly $5,000 payment gives the wife taxable income of $2,000.
Daughter and Nephew: Both are taxed the same way. The principal amount spread to each of the 10 years is $3,500 ($35,000 ÷ 10-year installment period). Subtracting this $3,500 from the yearly $5,000 installment gives the daughter and the nephew taxable income of $1,500 each.
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image Caution
Surrender of Policy for Cash
If the cash received on the surrender of a policy exceeds the premiums paid less dividends received, the excess is taxed as ordinary income (not capital gain). If you take, instead, a paid-up policy, you may avoid tax (6.12). You get no deduction if there is a loss on the surrender of a policy.
Tax may be avoided by a terminally ill individual on the surrender of a policy under an accelerated death benefit clause or on a sale of the policy to a viatical settlement company (17.16).
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