YOU ASK:

How do you report life insurance income on your federal tax return?

WE ANSWER:

When the life insurance proceeds are paid directly to the beneficiary and the life insurance is individually owned, it is not subject to income tax. In most cases, you don't need to report it. Otherwise, you will place this under the non-taxable "income" portion of your tax return.

The beneficiary has the freedom to spend the proceeds anyway he or she wants or needs and would not need to pay taxes for this. He can place it in the bank or invest it somewhere else. However, when the life insurance earns interest, the interest earnings would be subject to taxes and you will have to report this to the taxable section of your tax return.

Now, if the life insurance proceeds are paid to the Insured's estate and then paid to the heirs, the money becomes subject to probate tax. Please remember that there is a distinction between the two - whether the death benefit is paid to the beneficiaries or to the estate.

That said, if you (as a beneficiary) are receiving a lump sum death benefit, you will also have to report proceeds that were over and above the expected amount payable to you at the time that the insured person passed away. If you (as a beneficiary) are receiving the death benefit in installments, anything exceeding the expected installment amounts should also be reported as income.

Since tax returns can be a complicated thing, the best thing you can do is to consult your CPA or your tax attorney, to determine the best way to go about naming your beneficiaries, and whether it is wise to leave the insurance proceeds to the estate and not to the individual beneficiary. You can also consult them to see how you should report the life insurance proceeds you have received.

Remember, state tax laws covering life insurance proceeds may vary, so it will be in your best interest to consult with a professional who is more familiar with state laws.

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