One of the questions we hear most often regarding Life Insurance is “Are life insurance proceeds taxable when I die?” Generally speaking, the simple answer is no. Life insurance proceeds are not considered to be taxable income, and are therefore not taxable to a named beneficiary. We consider life insurance to be one of the most important gifts you can give to your loved ones. If you were to pass away, the life insurance payout could help your family in countless ways, such as paying for your final expenses or your children’s education, helping your spouse continue to pay the mortgage, or providing an inheritance for your grandchildren.

There are a couple of scenarios where there may be tax implications, and we’ll go into detail about those shortly. But for now, let’s assume that you’ve purchased a whole life insurance policy and have named your two children as equal beneficiaries. Assuming that your children initiate a claim with the life insurance company immediately after the funeral, they should not have to pay any taxes on the death benefit.

What is a death benefit?

Before we go into detail about potential tax implications with life insurance payouts. Let’s be sure we’re clear on what a death benefit is. The death benefit is the amount that the life insurance company will pay out when the life insured passes away. A life insurance policy is purchased for a specific coverage amount, which is known as the face amount. Some types of life insurance policies allow for additional amounts to be deposited into the policy, in the form of an investment account or additional paid-up insurance. As long as these additional amounts are paid out as part of the death benefit, they are not taxable. However, if any part of the cash value of the policy is withdrawn by the policyowner (prior to the death of the life insured), there may be tax implications.

So, when might taxes be charged on life insurance proceeds?

The first scenario in which proceeds may be taxable is if you don’t name a specific beneficiary, or if you name your estate as beneficiary on your policy. If you name one or more beneficiaries, the life insurance company will pay the death benefit directly to them, tax-free. However, if you have not named a beneficiary or is the estate is named, the proceeds may be subject to tax. For this reason, we always recommend that policyowners name specific beneficiaries on their life insurance policies. An added bonus to this is that, when a beneficiary has been named, proceeds pay out relatively quickly, in a matter of a few weeks. If the estate needs to get involved, this can add weeks or even months to the process.

The other scenario where a beneficiary may have to pay taxes on life insurance proceeds involves interest income. Generally, life insurance claims are settled shortly after the life insured passes away, so there isn’t really any time for the proceeds to accrue interest. However, sometimes beneficiaries don’t initiate claims immediately, or there may be other unavoidable delays. This means it does sometimes happen that proceeds earn interest before being paid out. This interest is considered to be taxable income, so beneficiaries will have to pay taxes on that income.

As we’ve explained, in most cases, life insurance proceeds are not taxable. If you’re ever unsure about taxable events with respect to your life insurance policies, please don’t hesitate to reach out – we’d be glad to review your plans and help you make sense of things.

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