Is Accrued Interest on a Life Insurance Payout Subject to Federal Income Tax?

Life insurance proceeds typically pay out tax-free to the beneficiary. Insurance companies may offer a number of ways for the beneficiary to receive the benefit, including taking a lump-sum distribution, scheduling regular payments plus interest over a number of years or leaving it for an indeterminate amount of time with the company earning interest. Interest generated by life insurance payouts are typically subject to federal income tax.

Interest From Date of Death

Typically, life insurance death claims are not filed the day that the insured passed away. Usually insurance claims come in the weeks after, as the family is taking care of the details after the funeral. In addition to the death benefit of the life insurance policy, the company typically pays back any unearned premium and interest on the death benefit from the day the insured died. This interest is taxable to the beneficiary, while the unearned premium is not because the insured paid using after-tax dollars.

Interest on Installment Payments

When you elect to receive periodic payments over a number of years rather than in one lump-sum payment, the insurance company typically pays interest on the remaining balance. The tax code treats installment payments of life insurance proceeds similar to annuities because the payout and the tax-exempt amounts are known up-front.

For example, a $250,000 policy may pay out $2,200 per month for 10 years for a total of $264,000. Each payment consists of death benefit and interest, according to the proportion of death benefit to total payout. Because $250,000 divided by $264,000 equals 95 percent, $110 of the $2,200 monthly payment is taxable interest.

Interest on Deposit

Sometimes you don’t need access to the proceeds right away. Many companies offer beneficiaries the option of keeping the payout on deposit, earning a preferential interest rate. Unlike installment payouts, the amount of interest you earn is uncertain.

Instead, the insurance company reports how much interest you earned on a Form 1099 each year. You must report the interest as income in the year that you earn it, even if you leave it on deposit with the company.

Interest Reporting Example

Taxpayer A’s father had a $100,000 life insurance policy against his life. When the father died, Taxpayer A submitted the claim and received a form that provided several options for receiving the funds. Taxpayer A elected to take $10,000 as a lump sum, $700 dollars in monthly payments for 10 years, and leave $10,000 on deposit with the company earning 5 percent interest. The company sends a check for $10,025 a week later, and begins sending $700 each month at the next month.

Taxpayer A received $25 of interest on the lump sum payment, and recognizes 5 percent, $35, of each monthly payment as interest. At the end of the first full year, the amount on deposit had accrued $50 of interest that Taxpayer A must report as well.