Generally speaking, when the beneficiary of a life insurance policy receives the death benefit, this money is not counted as taxable income, and the beneficiary does not have to pay taxes on it. However, a few situations exist in which the beneficiary is taxed on some or all of a policy's proceeds. If the policyholder elects not to have the benefit paid out immediately upon his death but instead held by the insurance company for a given period of time, the beneficiary may have to pay taxes on the interest generated during that period. When a death benefit is paid to an estate, the person or persons inheriting the estate may have to pay estate taxes on it.

Interest Income

Income earned in the form of interest is almost always taxable at some point. Life insurance is no exception. This means when a beneficiary receives life insurance proceeds after a period of interest accumulation rather than immediately upon the policyholder's death, he must pay taxes, not on the entire benefit, but on the interest. For example, if the death benefit is $500,000, but it earned 10% interest for one year before being paid out, the beneficiary owes taxes on the $50,000 growth.

Estate and Inheritance Taxes

In some cases, life insurance proceeds are paid to the estate of the deceased. This often happens when the policy's beneficiary precedes the policyholder in death and no contingent beneficiary is named. The death benefit adds to the value of the estate, which may be subject to estate taxes or inheritance taxes. The easiest way to avoid this situation is to name a primary and contingent beneficiary to a life insurance policy.

Advisor Insight

Robert E. Maloney, AEP
Squam Lakes Financial Advisors, LLC, Holderness, NH

A will can include an "apportionment clause” that leads to tax liabilities for the beneficiary. For instance, the clause may state that if there are any estate taxes due, they will be paid proportionally by the beneficiaries who receive the assets from the benefactor. Under this circumstance, there would be an estate tax due, but not an income tax. It is possible that some income tax may be due when the life insurance company pays out the proceeds of the policy to the beneficiary over an extended period of time. The face amount of the policy, however, is received income tax-free. The law also requires the insurance company to pay interest to the beneficiary from the date of death until they pay out the proceeds.