One of the significant benefits of a sizable life insurance policy, aside from taking care of family members or a significant partner after death, is the fact that it is generally exempt from income tax on the named beneficiary. This makes life insurance a powerful estate planning tool, especially when other estate assets do fall under inheritance tax and income tax after death.
Life insurance proceeds can be handled two ways upon death. They can be paid out as a lump sum or they can be held by the insurer and distributed in a series of installment payments over time. In both cases, the actual principle amount is tax-free from income tax. However, where the insurer earns interest on the payments held, that interest becomes taxable when paid to a beneficiary.
The above said, if the life insurance policy ownership is transferred to a third party prior to death, usually in exchange for a cash or asset payment in return, then funds paid to a beneficiary do become taxable as income. This sort of situation is rare, but when it does occur, the beneficiary should definitely consult with a certified tax expert for proper reporting.
All of the above said, estate tax can be a problem. If the life insurance policy was in any way controlled by an owner, it falls under “incidents of ownership.” This frequently occurs with whole life or permanent life plans that allow borrowing, assigning, changing the beneficiary, etc. Such criteria make the payout to a beneficiary taxable under federal estate tax. A spouse is exempted from this charge, but kids and third party beneficiaries are not. As of 2012 this charge triggered on estates bigger than $5 million, but this is a temporary limit through 2013. In past years the estate tax has hit after an estate exceeds $1 million in total.