63 / Are life insurance proceeds payable by reason of the insured’s death taxable income to the beneficiary?

Generally, no. As a general rule, death proceeds are excludable from the beneficiary’s gross income.¹ Death proceeds from single premium, periodic premium, or flexible premium policies are received income tax-free by the beneficiary regardless of whether the beneficiary is an individual, a corporation, a partnership, a trustee, or the insured’s estate.² With some exceptions (as noted below), the exclusion generally applies regardless of who paid the premiums or who owned the policy.

Note that death proceeds from certain employer-owned life insurance contracts received by the employer as beneficiary will not be excluded from the employer’s taxable income unless certain requirements are met ( Q 8776).³

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Planning Point: When presenting a key person proposal it is important to ask the prospect, “How much additional gross sales would it take to equal the income-tax-free benefits of life insurance?” Also point out that the sales revenue will be needed at a time when the business has lost a person critical to the creation of that revenue. William H. Alley, CLU, ChFC, MSFS, LUTCF, Alley Financial Group, LLC.

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Proceeds from group life insurance can qualify for the exclusion as well as proceeds from individual policies. Under certain conditions, accelerated death benefits paid prior to the death of a chronically or terminally ill insured may qualify for this exclusion ( Q 54). On the other hand, death benefits under annuity contracts do not qualify for the exclusion because they are not proceeds of life insurance within the meaning of IRC Section 101(a)(1).

In order to come within the exclusion, the proceeds must be paid “by reason of the death of the insured.” In other words, the exclusion applies only to proceeds that are payable because the insured’s death has matured the policy. When the policy has matured during the insured’s lifetime, amounts payable to the beneficiary, even though payable at the insured’s death, are not “death proceeds.” Proceeds paid on a policy covering a missing-in-action member of the uniformed services were excludable, even though no official finding of death had been made by the Defense Department.⁴

If death proceeds are paid under a life insurance contract (as defined in IRC Section 7702 and discussed in Q 65), the exclusion extends to the full amount of the policy proceeds. For example, if an insured dies after having paid $6,000 in premiums on a $100,000 policy, the full face amount of $100,000 is excludable from the beneficiary’s gross income (not just the $6,000 that represents a return of premiums). The face amount of paid-up additional insurance and the lump sum payable under a double indemnity provision also are excludable under IRC Section 101(a)(1). When the death proceeds are received in a one sum cash payment, the entire amount is received income tax-free. However, the exclusion does not extend to interest earned on the proceeds after the insured’s death. Thus, if the proceeds are held by the insurer at interest, the interest is taxable ( Q 70). If the proceeds are held by the insurer under a life income or other installment option, the tax-exempt proceeds are prorated over the payment period, and the balance of each payment is taxable income ( Q 71).

Generally, in the case of a contract issued after 1984 that is a life insurance contract under applicable law but that does not meet the definitional requirements explained in Q 65, only the excess of the death benefit over the net surrender value (cash surrender value less any surrender charges) will be excludable from the income of the beneficiary as a death benefit.⁵ Generally, the exclusion is similarly limited to the amount of the death benefit in excess of the net surrender value in the case of a flexible premium contract that is subject to, but fails to meet, the guidelines of IRC Section 101(f) ( Q 65). Nevertheless, in either case, a part of the cash surrender value also will be excludable as a recovery of basis to the extent the basis has not been previously recovered; presumably, when a contract subject to the definition of a life insurance contract in IRC Section 7702 fails to meet that definition, or when a variable contract is not adequately diversified, unrecovered cash value increases previously includable in income will be recoverable tax-free as a part of basis.

In addition, all or part of the proceeds may be taxable income in the following circumstances:

• In some instances, the policy or an interest in the policy has been transferred for valuable consideration ( Q 77, Q 279);


• The proceeds are received under a qualified pension or profit-sharing plan ( Q 3968);


• The proceeds are received under a tax-sheltered annuity for an employee of a tax-exempt organization or public school ( Q 4051);


• The proceeds are received under an individual retirement endowment contract ( Q 3674);


• The proceeds are received by a creditor with no other insurable interest from insurance on the life of the debtor ( Q 135, Q 136);


• There is no insurable interest in the life of the insured ( Q 292);


• The proceeds are received as corporate dividends or compensation ( Q 291);


• The proceeds are received as alimony by a divorced spouse ( Q 106);


• The proceeds are received as restitution of embezzled funds ( Q 293); and


• Proceeds received by a corporation may be subject to an alternative minimum tax ( Q 316) (but note that the corporate AMT was repealed for tax years beginning after 2017).