Death benefits payable to a beneficiary under a life insurance policy are generally

To start, let’s define death benefit: It’s the money – lump sum or otherwise – that gets paid to your beneficiaries if you die while your life insurance policy is in effect. Whether you’re buying life insurance, or you’re filing a claim on a life insurance policy, there are a few things you need to know about beneficiaries:

• A beneficiary needs to be specifically designated in the life insurance policy 
• There can be more than one beneficiary – and in practice, there often is
• A beneficiary doesn’t have to be a person – it can also be an entity such as a charity, family trust, or even a business

An heir is not necessarily the same thing as a life insurance beneficiary

 An heir is assumed, but a beneficiary is designated. This means that if a person dies intestate (i.e., without a will), his or her heirs are the people who may be legally entitled to inherit the deceased’s estate – their spouse, children, and so forth1. One or more heirs are usually named as beneficiaries on a life insurance policy, but they don’t have to be. In fact, there are many reasons for naming someone other than your spouse or children as beneficiaries, including:

• You want to leave money to care for other family members, such as parents or a sibling
• You could leave money to a family-run business to help ensure continuity of operations after you’re gone
• You decide to leave money to your grandchildren (instead of your children) as part of your tax strategy 

Even though anybody can be named as a beneficiary, you may need permission from your spouse

The most common reason people buy life insurance is to help protect their family’s financial well-being. That’s why married people commonly designate their spouse as the only primary beneficiary, especially when their children are still at home. However, if you live in a state with common property laws, you must name your spouse as the only beneficiary unless you have his or her consent to name someone else. One more thing: underage children can’t ordinarily be named as beneficiaries; if you want to leave money to a minor, you may have to set up a trust to manage the financial payout until they become of age.

Beneficiaries can be changed

When you buy an insurance policy, you can designate each beneficiary as either revocable or irrevocable. When beneficiaries are irrevocable, it can be difficult to remove them from policies or change their share without their consent. For revocable beneficiaries, the change process is relatively easy and you don’t need permission (unless it’s your spouse and you live in a common property state). For example, with Guardian, a beneficiary change can be done online in a few minutes by going to GuardianLife.com and signing in or registering for an account. Other life insurance companies may require a phone call or ask you to fill out a paper form and send it back. An annual review with your agent or financial professional can be a great time to ensure your beneficiaries are up to date.

A life insurance death benefit can be divided up any way the policyholder wants

If you’re one of four beneficiaries, that doesn’t automatically mean you’ll get one quarter of the death benefits. The policyholder can allocate different percentages to different beneficiaries. 

Beneficiaries can use the money any way they want

There are no stipulations or conditions on benefit payouts. You can take the lump sum and use it for living expenses if you need, but you can also use it for any other purpose, from education to retirement savings – or even going on vacation.

The payout may not be subject to taxes

Generally speaking, life insurance death benefits are exempt from income tax (which is one of the most important life insurance tax benefits). While the benefit is usually income tax-free, you should consult with your tax advisor if you receive a death benefit payment.

Sometimes, part of the benefit can be paid out before death

Many life insurance policies have an Accelerated Death Benefit rider (i.e., optional provision) which allows policyholders with a terminal illness to access part of the death benefit amount while they are still alive – usually to help pay for needed care2. The company may need Proof of Life Expectancy from a medical provider in order to accelerate the death benefit; sums paid out will typically reduce the amount disbursed to beneficiaries after death.

Under certain circumstances a death benefit may be decreased

While every reputable company has a long history of paying out insurance death benefits in full, there are some situations in which a death benefit may be reduced:

• If an Accelerated Death Benefit was provided (see above)
• If the policyholder willfully misrepresented his or her information during the application process to obtain lower premiums, the company can reduce the benefit amount accordingly – or in some cases cancel coverage altogether
• If there were outstanding loans against the cash value (this is typically not applicable to a term life policy with no cash value)
• If the policy had an adjustable death benefit (which can be a feature of universal life insurance policies designed for flexibility), the payout may be lower than the original coverage amount
   

Beneficiaries can be charities or other 501(c)(3) organizations

As a means of creating a legacy, some policyholders may choose to designate a charity or other organization as their beneficiary. On some products, a policyholder can even elect to use certain options like a charitable benefit rider, which automatically provides a payout to the charity of their choice above and beyond the beneficiary payout.3

Life insurance inheritances go directly to the beneficiaries who are named on the policies. They typically don't become part of the decedent's probate estate, so you should be spared the headache of probate.

Inheriting life insurance can bring tax and other consequences, however, and it occasionally happens that the company refuses to pay out at all.

You can collect policy death benefits by sending the original death certificate and the original life insurance policy to the insurer if you're named as the beneficiary. More commonly, the insurer will provide you with a claim form upon notification of the decedent's death.

The company will transmit the money directly to you. It doesn't go to or become part of the policy holder's probate estate, although it can contribute to the decedent's gross estate for estate tax purposes. 

You may have no idea that you are entitled to death benefits after the death of a certain person you know. There are ways to find out if you are in for a pleasant surprise.

Some policies name more than one individual to receive the death benefit proceeds when the insured dies. The money is normally divided equally among them when this is the case.

Should one beneficiary predecease the insured, that individual's share would normally pass to any other named beneficiaries to be shared equally among them. The deceased's estate would take the proceeds only if none of the policy's beneficiaries are living.

It's possible for an insurer to refuse to pay out benefits under some circumstances, but generally only if the policy provides for it.

Insurers will generally not pay out when the deceased has committed suicide within the first two years. They might also decline to pay if the insured smoked, regularly engaged in and died engaging in dangerous activities such as drag racing, or died during the commission of a crime.

All these terms are typically spelled out in the policy, but health-related issues can be tricky. Maybe the deceased didn't smoke at the time he took out the policy, but then he started. Insurers can refuse to pay out benefits if the policy was conditioned on the insured not being a smoker.

The same can apply to undivulged health conditions, such as high blood pressure or cancer, but the insurance company would most likely have to prove that the insured was aware of the condition at the time the policy was taken out and that it wasn't diagnosed for the first time years later.

You don't have to pay income tax on the initial policy proceeds when you're the beneficiary of a life insurance policy. The Internal Revenue Service doesn't consider death benefits to be income.

Any interest earned by the proceeds would be taxable, however, if the policy earns income after the date of death. This might happen if you don't take the benefits in one lump sum but rather stretch them out in installments over a period of years. The balance retained by the insurer would keep growing, so you'd be taxed on that additional interest.

The same would happen if you took all the proceeds at once and plunked the money down in a savings or investment account. Any interest or dividends earned would be taxable income.

You must include this income on your tax return just as you would report any other interest or unearned income you received during the tax year.

There's no inheritance tax at the federal level, but six states do impose this tax as of 2020: Nebraska, Iowa, Kentucky, Pennsylvania, New Jersey, and Maryland.

This isn't an income tax, but rather a percentage of the value of the assets you inherit.

Some states that do have inheritance taxes, such as New Jersey, specifically exempt life insurance proceeds from taxation. 

Life insurance proceeds contribute to the value of a decedent's taxable estate if the decedent was the owner of the policy or if the decedent transferred ownership within three years of death, such as into an irrevocable living trust.

A decedent's estate is liable for federal estate taxes if it's valued at more than $11.58 million as of 2020. Any balance of value over this threshold is taxable. Twelve states and the District of Columbia also impose estate taxes as of 2020, some with much lower exemptions. Those states and their exemptions are:

• Connecticut: $5,100,000
• District of Columbia: $5,760,000
• Hawaii: $5,490,000
• Illinois: $4,000,000
• Oregon: $1,000,000
• Maine: $5,800,000
• Maryland: $5,000,000
• Massachusetts: $1,000,000
• Minnesota: $3,000,000
• New York: $5,850,000
• Rhode Island: $1,580,000
• Vermont: $4,250,000
• Washington: $2,193,000

There's a sizable difference between the $11.58 million federal exemption in 2020 ($11.7 million in 2021) and the $1 million exemption that's available in Oregon and Massachusetts.

Beneficiaries of life insurance proceeds are not usually responsible for paying the estate tax, however, unless the decedent's last will and testament contains specific provisions asking them to contribute some of the death benefit proceeds to satisfy the tax burden.

The named beneficiary on a policy generally isn't required to use any of the death benefit proceeds to pay off the decedent's debts. The probate process typically pays the deceased's creditors and final bills from estate funds and, if necessary, by liquidating estate assets.

Life insurance proceeds that go directly to a named beneficiary never become part of the decedent's probate estate, so the money isn't available to creditors. Beneficiaries have no legal obligation to use the money to satisfy the decedent's debts unless they also happen to be cosigners on the loans.

Related: Best Whole Life Insurance Policies

Spouses can additionally be held responsible for some medical bills in community property states.

Life insurance proceeds would be used to pay estate debts if the insured named their estate as the policy's beneficiary. The deceased might do this intentionally to address issues of settling large estate settlement expenses or estate taxes.

A life insurance annuity is a contract with the insurer. The owner collects annuity payments during their lifetime and can name a beneficiary to receive the payments after their death if the annuity comes with death benefits. The earnings portion of the payments are taxable as income.

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