What Is the Tax Percentage on Life Insurance?

In general, life insurance death benefits paid out in a lump sum to a beneficiary are not considered income to the recipient of the life insurance payout. This tax-free exemption also applies to death benefit payments made under endowment contracts, worker's compensation insurance contracts, employer-sponsored group plans, or accident and health insurance contracts.

Breaking It Down

Although the death of a loved one cannot be planned or predicted, it is critical to work with an experienced tax and estate planner to avoid the IRS collecting where it is not required. As a result, rather than a "how-to," this article should be used as a checklist to ensure that your life insurance policy is in the right place. It is perfectly acceptable to consult with your estate planner to ensure that your insurance payouts go to the correct recipients.

Taxes Paid on Excess Interest 

The exclusion does not apply if a policy is combined with a non-refund life annuity contract with a single premium equal to the face value of the insurance paid. For example, if the face value of the death benefit is $250,000 and the beneficiary chooses monthly payments rather than the lump sum amount, any additional interest received above the $250,000 face amount is taxable.

Unlike life insurance, the amount of taxes a beneficiary may owe on an inherited annuity can vary depending on the annuity contract's structure and whether the beneficiary is a surviving spouse. Also, if the inherited annuity was part of the decedent's defined contribution plan, such as a 401(k), rules from the Setting Every Community Up for Retirement Enhancement (SECURE) Act may apply to when the beneficiary can take distributions and how much tax is owed. Because annuity rules can be complicated, you should consult with a qualified tax expert about your tax obligations.

Complications With Ownership and Estate Planning

While life insurance death benefits are generally exempt from income tax for the beneficiary, they are included in the deceased's estate if the deceased was the policy's owner at the time of death. This inclusion as part of the estate may subject the benefit paid to federal and state estate taxes. If the owner of the life insurance policy is someone other than the deceased, estate inclusion can be avoided; however, this assignment must have occurred more than three years prior to the date of death, or the IRS will still consider the deceased as the policy owner for estate tax purposes.