Are Death Benefits That Are Received by a Beneficiary Taxable?
Life insurance proceeds can be used to pay off the debts of the decedent, or they may be used to pay for your own financial expenses. Death benefits are income tax-free. But, depending on what you do with the death benefit proceeds, you may actually end up owing tax on some of the proceeds you get from the life insurance company.
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Lump Sum
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If you take the life insurance benefit as a lump sum, there is no income tax on the death benefit. This is the most basic way to take death benefits. This puts you in control of what happens to the death benefit, but it also imposes significantly more responsibility on you in terms of what you do with the money.
Reinvestment
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If you leave the death benefit with the insurance company to accumulate interest, the death benefit will not be taxable. However, any interest that the death benefit earns will be taxed at ordinary income tax rates. This type of claim is helpful when you may need a consistent and steady income from the proceeds but do not want to give up control over the total death benefit amount.
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Annuity Payments
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You can take the death benefit in the form of monthly payments. This involves converting the death benefit into an annuity. Annuity payments are taxed at ordinary income tax rates. Your annuity payments are considered primarily a return on principal (the original death benefit), with only a small amount of interest added to the payment. For this reason, you will not have to pay tax on all of the payment. Generally, you can expect the payment to be more than a 95 percent return on the death benefit and 5 percent or less in interest. Only the interest payment is subject to income tax. This payment is ideal if you need regular income that is guaranteed but you want to lower your income tax liability.
Consideration
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Before taking your death benefit, you should consider your financial goals. If you need your policy to provide you with an income, investing the death benefit or choosing an annuity option will be best. Paying taxes on your death benefit distribution can be a small price to pay if the money you earn on investments helps you meet your financial goals.
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