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Do Beneficiaries Pay Taxes on Life Insurance?

As a general rule, they do not, but these solutions can help when they do.

When a life insurance policy's beneficiary receives the death benefit, that money is not counted as taxable income, and the beneficiary does not have to pay taxes on it.

However, there are circumstances in which the beneficiary pays taxes on some or all of a policy's proceeds. If the policyholder chooses not to have the benefit paid immediately after their death, but instead has the life insurance company hold it for a specified period, the beneficiary may have to pay taxes on the interest earned during that period (see the FAQs on the IRS website). And when a death benefit is paid to an estate, the person or people who inherit the estate may have to pay estate taxes [1].

However, there are several ways to avoid these estate taxes.

Interest Income

Interest income is always taxable at some point, and life insurance is no exception. This means that when a beneficiary receives life insurance proceeds after a period of interest accumulation rather than immediately after the policyholder's death, the beneficiary must pay taxes on the interest, not the entire benefit.

For example, if the death benefit is $500,000 but earns 10% interest over a year before being paid, the beneficiary owes taxes on the $50,000 growth.

According to the IRS, if a life insurance policy was transferred to you in exchange for cash or other assets, the amount you exclude from gross income when filing taxes is limited to the sum of the consideration you paid, any additional premiums you paid, and certain other amounts. In other words, you cannot overpay for a policy as a way to reduce your taxable income.


Estate and Inheritance Taxes


Investors frequently name "payable to my estate" as the beneficiary of a contractual arrangement, such as an individual retirement account (IRA), an annuity, or a life insurance policy. However, when you name your estate as beneficiary, you eliminate the contractual advantage of naming an actual person and subject the financial product to probate. Leaving assets to your estate also increases its value and could subject your heirs to exceptionally high estate taxes.

Section 2042 of the Internal Revenue Code states that the value of life insurance proceeds covering your life is included in your gross estate if the proceeds are payable:

  • To your estate, directly or indirectly
  • To designated beneficiaries, if you possessed any "incidents of ownership" in the policy at the time of your death [2]
  • Using an ownership transfer to avoid taxes
  • Many estates will owe no federal taxes. Under the Tax Cuts and Jobs Act (TCJA) of 2017, the exemption amount increased to $11.7 million for 2021 and $12.06 million for 2022. Meanwhile, the top estate tax rate is capped at 40% [3].

Many changes enacted by the Tax Cuts and Jobs Act, including the increased federal estate tax exclusion, are currently scheduled to expire at the end of 2025 unless Congress extends them [4].


For estates that will owe taxes, whether life insurance proceeds are included in the taxable estate depends on who owns the policy at the time of the insured person's death. If you want your life insurance proceeds to avoid federal taxes, you will need to transfer ownership of your policy to another person or entity.

Some Guidelines to Remember When Considering an Ownership Transfer

  • Choose a competent adult or entity to be the new owner, who may be the policy's beneficiary, then call your insurance company to obtain the appropriate assignment or ownership transfer forms.
  • The new owners must pay the policy premiums.
  • You will surrender all rights to make future changes to this policy. However, if a child, family member, or friend is named the new owner, they can make changes at your request.
  • Because an ownership transfer is irrevocable, be mindful of divorce situations when planning whom to name as the new owner.
  • Obtain written confirmation from your insurance company as proof of the ownership change.

Gift Tax

  • If three different people are listed as the insured person, policy owner, and beneficiary, a gift tax may apply because, in most cases, the insured person and policy owner are the same. However, if the insured person is different from the policy owner, the IRS will treat the death benefit amount as a gift from the policy owner to the beneficiary, and gift taxes may be owed on that amount.

  • Once you die, the gift tax becomes due, but the death benefit's beneficiary will not have to pay it unless it exceeds $12.06 million, including any gifts made in excess of $16,000 per year [5].

  • If you die within three years after transferring ownership, the full proceeds are included in your estate as though you still owned the policy [6].

Using Life Insurance Trusts to Avoid Taxes

A second way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT).

To complete an ownership transfer, you cannot serve as the trust's trustee and cannot retain any right to revoke the trust. In this case, the policy is held in trust, and you are no longer considered the owner. Therefore, the proceeds are not included in your estate.

Why choose trust ownership instead of transferring ownership to another person? One reason might be that you still want to maintain some legal control over the policy. Or perhaps you worry that an individual owner will fail to pay premiums, while through the trust you can ensure that all premiums are paid on time. If the proceeds' beneficiaries are minor children from a previous marriage, an ILIT allows you to name a trusted relative as trustee to manage the children's money under the terms of the trust document.

Life Insurance Policy Ownership Rules

The IRS has developed rules that help determine who owns a life insurance policy when an insured person dies. The main regulation governing proper ownership is known in the financial world as the three-year rule, which states that any gifts of life insurance policies made within three years of death remain subject to federal estate tax. This applies both to transferring ownership to another person and to establishing an ILIT [7].

The IRS will also look for any incidents of ownership retained by the person transferring the policy. When transferring it, the original owner must surrender any legal right to change beneficiaries, borrow against the policy, surrender or cancel it, or select the beneficiary's payout options.

In addition, the original owner must not pay premiums to keep the policy in force. These actions are considered part of owning the assets, and taking any of them may negate the tax advantage of disposing of them [8].

However, even if a policy transfer meets all requirements, some transferred assets may still be taxable. If the policy's current cash value exceeds the gift tax exclusion of $15,000 in 2021 and $16,000 in 2022, gift taxes will be calculated and paid when the original policyholder dies.

Do You Have to Pay Taxes on Money Received as a Beneficiary?

Normally, you do not have to pay taxes on life insurance money received as a beneficiary.

Do You Pay Taxes on Inherited Life Insurance Money?

No. You do not have to pay taxes on inherited life insurance money unless the life insurance benefit has accumulated interest. If that happens, you may have to pay taxes on the interest.

How Do I Avoid Taxes on Life Insurance Proceeds?

Life insurance proceeds are generally not subject to estate or income taxes.

Do I Need to Report an Inheritance to the IRS?

Most inheritances do not need to be reported to the IRS.

It is not unusual for people to be insured under a life insurance policy with death benefits ranging from $500,000 to several million dollars. Once you add the value of your home, retirement accounts, savings, and other belongings, you may be surprised by the size of your estate. With additional years of growth, some people may face an estate tax problem.

One viable solution is to maximize your gifting potential and transfer policy ownership whenever possible with little or no gift tax cost. As long as you live another three years after the transfer, your estate could save a significant amount in taxes.

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