Do Beneficiaries Pay Taxes on Life Insurance?

When beneficiaries receive a payout from a life insurance policy, they typically don’t owe taxes on that money. However, there are a few situations where a portion of the life insurance benefit is taxable to the beneficiary. Whether you have a life insurance policy or are the beneficiary of one, here’s what to know about life insurance payouts and taxes.

A financial advisor can help you figure out how life insurance fits into your financial plan.

What Is a Death Benefit?

A death benefit is a crucial component of life insurance policies, providing financial security to beneficiaries upon the policyholder’s passing. This payout is typically a lump sum, designed to help cover expenses such as funeral costs, outstanding debts or even future financial needs, such as college tuition for children. It helps ensure that loved ones are not left in financial distress during an already challenging time.

When you take out a life insurance policy, you must name a beneficiary who will benefit from the policy’s proceeds. As a policyholder, you can name spouses, children, friends or almost anyone else as a beneficiary. Then, when the policyholder passes away, the policy’s beneficiary receives a payout known as the death benefit.

The death benefit amount depends on the type of life insurance policy and the insurance company that issued it. Beneficiaries can receive anywhere from a few thousand dollars to over $1 million.

When Is Life Insurance Taxable?

The primary benefit of life insurance is that upon death, your heirs or beneficiaries can receive a substantial lump sum payment without being subject to federal taxes.

Death benefits are usually tax-free. But there are a few situations where a beneficiary may have to pay taxes on the lump sum payout.

1. Earned Interest

When you earn income from interest, it’s typically taxable. In other words, if the beneficiary decides to delay the payout instead of receiving it immediately, the death benefit has the opportunity to accumulate interest. Therefore, although the death benefit will not be taxed, the beneficiary is still typically required to pay taxes on the additional interest.

For example, let’s say the lump sum payout was $100,000, and the beneficiary chose to wait two years before taking death benefits. During that two-year period, the death benefit earned 10% interest. Therefore, the beneficiary owes taxes on that $10,000 accumulation.

2. Estate and Inheritance Taxes

If a life insurance policyholder decides to name their estate as the death benefit beneficiary, the estate could be subject to taxation. When you forgo naming an individual as your beneficiary, the proceeds from the life insurance policy fall subject to Section 2024 of the IRS code.

This code states that if the gross estate incorporates proceeds of a life insurance policy, the value of a life insurance policy must be payable to the estate directly, indirectly or to the named beneficiaries (if you had any incidents of ownership throughout the policy term).

Remember, most estates won’t be subject to federal taxation since the exclusion amount is $13.99 million per person in 2025 and $15,000,000 in 2026 with a 40% tax rate cap.

3. No Contingent Beneficiaries Named

The proceeds of a life insurance policy may also pass to the estate if the beneficiary dies and there are no contingent beneficiaries. In this case, the proceeds will be paid out according to the terms of your will, if you have one.

However if there is no will in place, the probate court will determine how to distribute your assets. Remember, probate is a time-consuming and expensive process that can minimize the size of your estate for your heirs.

4. Three Individuals Are Named on the Policy

Usually, the policyholder and the person insured on a life insurance policy are the same. The policyholder then designates a beneficiary.

However, a gift tax may apply if the insured, the policyholder and the beneficiary are three different parties. This situation creates what’s known as the Goodman triangle. Because the IRS assumes that the death benefit was a gift from the policyholder to the beneficiary, you may have to pay gift taxes on the death benefit.

For example, let’s say your spouse buys a life insurance policy for you, naming your adult children the beneficiaries. In this case, three people are named in the policy: your spouse (the owner), you (the insured) and your adult children (the beneficiaries).

Therefore, if you pass away, the IRS considers the death benefits a gift from your spouse to you and your children, thus creating a taxable event. Furthermore, you would have to file a gift tax return for your children on the proceeds of the life insurance policy.

The annual exclusion is $19,000 in 2025 and 2026, up from $18,000 in 2024. That means gifts exceeding this threshold count against a person’s lifetime gift and estate tax exemption. For example, a $25,000 gift made in 2025 would lower the giver’s lifetime exemption by $6,000.

5. Employer-Provided Group Life Insurance

If your employer provides group term life insurance coverage over $50,000, the value of the coverage above that limit is considered taxable income to you.

The IRS calculates the taxable amount using uniform premium rates based on age brackets. For example, if your employer provides $200,000 in coverage, the excess $150,000 would be included as taxable income each year.

How to Avoid Taxes on Life Insurance Benefits?

A woman reviewing a life insurance policy.

Many life insurance policies, particularly whole life and universal life, accumulate cash value over time. This cash value can be accessed through loans or withdrawals, offering a tax-advantaged way to tap into your policy’s value.

This can be subject to taxation, but there are ways to avoid these taxes entirely.

Notify your beneficiaries. It may seem counterintuitive, but plenty of life insurance proceeds go unclaimed because beneficiaries were not aware of the policy. After taking out a life insurance policy, be sure to immediately provide your beneficiaries with all the applicable details, including the insurance company’s name and instructions on how to file a claim after your death.
Name your beneficiaries. When there’s no beneficiary, the proceeds of a life insurance policy transfer to the owner’s estate, triggering a taxable event. To avoid this, be sure to name a primary beneficiary and at least one contingent beneficiary. It’s also wise to regularly review and update your beneficiaries to ensure the death benefit goes to the right person. For example, if you just got married, you may want to update your beneficiary to your spouse.
Share distribution benefits. Upon your death, a beneficiary can decide how to receive the death benefit, with options including a lump sum payment or interest payments. Choosing a lump sum payment can often be the better choice, as it helps the beneficiary avoid taxation on interest. Plus, they can immediately use the funds for more immediate financial needs, such as their mortgage payments or paying off other debt.
Consider placing the policy in an irrevocable life insurance trust (ILIT). An irrevocable life insurance trust (ILIT) removes the policy from your taxable estate. This can help your heirs avoid estate taxes on the death benefit. The trust becomes the policy owner and beneficiary, and the proceeds are managed and distributed under the trust’s terms rather than through your estate.

Bottom Line

A couple reviewing a life insurance policy.

Beneficiaries typically do not have to pay taxes on life insurance proceeds but, there are some situations that can result in a taxable event. Ensuring your beneficiary designations are clearly outlined in the policy is one of the best ways to avoid taxation.

However, because everyone has a unique situation, it’s best to consult with both a financial advisor and tax professional.

Tips for Planning Your Estate

When planning your estate, it’s wise to work with a financial advisor who can guide you and offer advice. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Probate is often cumbersome, time-consuming, and expensive, especially after losing a loved one. After you pass away, your successor trustee can distribute your trust assets directly to your beneficiaries.