Life insurance windfalls can be substantial. If you're named as a life insurance beneficiary, there's a good chance that your eventual payout will change your financial situation for the better. Depending upon the amount of debt that you're carrying on your ledger, your payout could significantly change your lifestyle. Even if you have a relatively high debt load and need to use most of your payout to remain solvent, you're sure to welcome your benefactor's largess. After all, you'd stand to lose a great deal of money without it.
If you know that you're the beneficiary of your spouse's life insurance policy, you may have made some contingency plans in the event of his or her death. However, you might not have considered the tax implications of your windfall. Once you receive your death benefit, you'll need to be familiar with your state's tax laws.
In most cases, life insurance benefits are exempt from state and federal taxation. This exemption applies to the death benefits on virtually all forms of traditional life insurance and most forms of life assurance. If your spouse has a term life insurance policy that's worth $300,000, you won't have to pay taxes on any portion of its eventual payout.
Different rules may apply to pre-death payouts. If your spouse's policy is structured as a whole life insurance plan, its death benefit won't be subject to taxation. However, you may be required to pay some taxes on its "cash-out" value. If you choose to redeem your whole life insurance policy for its cash value after a decade or two, the proceeds could be treated as capital gains. In this case, you'll need to check with your investment professional to determine your family's tax liability.
Different rules may also apply to employer-sponsored life insurance plans. Since most of these plans carry death benefits of less than $50,000, these rules rarely come into play. However, more robust employer-sponsored plans do come with significant tax liabilities. Under current federal income tax statutes, any death benefit that exceeds the $50,000 tax-free cap is subject to taxation at regular income tax rates.
It's important to note that such a benefit isn't treated as an inheritance or trust disbursement. If your spouse dies during his or her employer-sponsored life insurance plan's active term, you won't need to worry about paying additional "death tax" rates. In most cases, you'll simply add the total taxable amount to the "gross income" section of your tax return.