3975 / How is a beneficiary taxed on life income or installment payments of a death benefit under a qualified plan when an employee dies before retirement?

If a beneficiary has no cost basis for the payments, each payment will be fully taxable as ordinary income when received. The beneficiary’s cost basis generally is the same as the employee’s cost basis ( Q 3973). In the case of decedents dying before August 21, 1996, the $5,000 death benefit exclusion was included in the beneficiary’s cost basis.¹

If the beneficiary does have a cost basis, payments are subject to the rules that follow, depending on whether the death benefits come from life insurance proceeds.

If death benefit payments do not come from life insurance proceeds, the beneficiary is taxed as the employee would have been taxed had the employee lived and received the periodic payments ( Q 3968, Q 3969). The beneficiary’s cost basis, rather than the employee’s cost basis, is used. Depending on the annuity starting date, an exclusion ratio may have to be determined; if so, the beneficiary’s cost basis is used as the investment in the contract (for an explanation of the basic annuity rule and its application to various types of payments see Q 527 to Q 552). For annuities with a starting date on or before November 19, 1996, if a beneficiary elected the simplified safe harbor method for taxing annuity payments ( Q 613) and increased the investment in the contract by any employee death benefit exclusion allowable, the beneficiary had to attach a signed statement to his or her income tax return stating that the beneficiary was entitled to such exclusion in applying the safe harbor method.² After such date, if the annuitant is under age 75, the simplified method is required, rather than optional.³ When more than one beneficiary is to receive payments under a plan, the cost basis, including the $5,000 exclusion, if available, is apportioned among them according to each beneficiary’s share of the total death benefit payments.

If death benefit payments do come from life insurance proceeds, the proceeds are divided into two parts: the amount at risk, which are proceeds in excess of the cash surrender value immediately before death, and the cash surrender value.⁴

The portion of the payments attributable to the amount at risk is taxable under IRC Section 101(d) as life insurance proceeds settled under a life income or installment option, as the case may be ( Q 71). The amount at risk generally is prorated over the payment period, whether for a fixed number of years or for life, and the prorated amounts are excludable from the beneficiary’s gross income as a return of principal.

Where payments are for life, the beneficiary’s life expectancy generally is taken from IRS unisex annuity tables V and VI.⁵

The portion of the payments attributable to the cash surrender value is taxed in the same manner as any other periodic payments from a qualified plan.

Example: The widow of an employee who died on June 1, 2024 elects to receive $25,000 of life insurance proceeds in 10 annual installments of $3,000 each. The cash surrender value of the policy immediately before the insured’s death was $11,000. The employee made no contributions to the plan and the aggregate one-year term costs of life insurance protection that were taxed to the employee amounted to $940. The widow must include $1,506 of each $3,000 installment, computed in the following manner.

Face amount of insurance contract	$25,000
Cash value immediately before death	11,000
Excludable as life insurance proceeds	$14,000
Portion of each installment attributable to life insurance proceeds (14/25 of $3,000)	$ 1,680
Excludable as return of principal ($14,000 ÷ 10)	1,400
Includable in gross income	$ 280
(If the beneficiary is the surviving spouse of an employee who died before October 23, 1986, the $280 would be excludable under the $1,000 annual interest exclusion)
Portion of each installment attributable to cash surrender value
of the contract (11/25 of $3,000)	$ 1,320
Beneficiary’s cost basis ($940)	$ 940
Expected return (10 x $1,320)	$13,200
Exclusion ratio ($940/$13,200)	7.12%
Amount excludable each year (7.12% of $1,320)	$ 93.98
Includable in gross income ($1,320 - $93.98)	$ 1,226.02

The beneficiary may be entitled to an income tax deduction for any estate tax attributable to the decedent’s interest in the plan ( Q 3993).⁶ It would seem that the deduction would be prorated over the beneficiary’s life expectancy, in the case of life income payments, or over a fixed period, in the case of installment payments ( Q 544).