For many, the federal tax code is confusing and complex. In most cases, you are required to pay taxes according to the total annual income you earned. In theory, the U.S. tax laws are set up to favor low-income workers over high-income workers, and every working citizen is taxed on a case-by-case basis. However, it is important to understand the differences in the type of income you receive as you may not be required to pay taxes on everything.
The government will tax your income at one of a few “marginal rates” each year, and these rates will fluctuate from year to year. While any unearned income you receive must be claimed as part of your gross income on the tax return, certain types of unearned income are not considered taxable by the Internal Revenue Service and will not factor into the final calculation of your taxable income. What the IRS considers to be “unearned income” includes court settlements and unemployment benefits. In almost all cases, life insurance payouts also fall into this category of income. If you are named as a beneficiary on a life insurance policy, you will generally not need to claim the income you receive.
However, there is one exception to this rule. If the life insurance policy is through an employer-sponsored plan, a portion of those benefits may be taxable under federal law. In addition, at least $50,000 of these benefits are claimable as unearned income. However, if you received benefits in excess of $50,000, you will need to pay taxes on any additional benefits that you have received. For example, if your employer-sponsored plan carriers a death benefit of $500,000, you will be required to pay taxes on 87.5 percent of the proceeds that you receive. In addition, any interest received is also taxable, and you should report it to the IRS just as you would with any other type of interest.
Keep in mind that the minimum benefit payout subject to state estate taxes can vary from state to state. Rather than assuming that all life insurance benefits are not taxable, it may be in your best interest to speak with an experienced tax preparation specialist or your tax attorney. Your state’s revenue service can also be a valuable resource as in certain areas of the country, there may be specific state-level exceptions to the “unearned income” rule that oversees proceeds from life insurance policies.