Table of Contents
Key Takeaways
- Death benefits can be used to pay off mortgages, other debts, establish college funds, set up income streams, or invest for the future.
- Taxes on death benefits vary depending on the source of the money, with life insurance proceeds typically being tax-free.
- Investments like stocks and real estate receive a "step-up" in basis, potentially reducing the tax burden for beneficiaries.
- Inherited retirement accounts have different tax treatments based on the type of account and the relationship with the deceased.
- Annuities are taxed as regular income, with interest earned on the initial amount deposited being subject to income tax.
A death benefit is a payment to a beneficiary. The money could come from different types of investments such as stocks, bonds and real estate, or from annuities, life insurance or retirement accounts (e.g., and individual retirement account (IRA), Roth IRA, 401(k), etc.).
How Could a Death Benefit Be Used?
If you're a beneficiary, you will have some important decisions to make, regardless of where the money comes from. Since everyone's circumstances and financial needs are different, there is no one-size-fits-all solution. Here are several common uses for a death benefit.
Pay off a Mortgage
A home can be a large asset and a large financial responsibility. If a loved one dies and leaves behind a mortgage to pay, you could use a death benefit to pay off all of, or a portion of, the mortgage. This could help your family remain in the home or limit the debt that's owed before you sell the property.
Pay off Other Existing Debt
In conjunction with a mortgage, other household debt may exist and could be a priority. Using a death benefit to help pay off debt may be the best option for you.
Set up a College Fund
After necessary expenses are covered, establishing a college fund for your child (or children) might also be a priority. A death benefit can help fund a 529 college savings plan for you, your child or another family member.
Set up an Income Stream
If you depended on your deceased loved one's income, a death benefit may be used to set up a stream of income through an annuity. This could be a helpful option if family members relied on the deceased person's income to pay for household expenses, such as a mortgage, car loans or credit card debt.
Invest in Your Future
Contributing to an investment account today could help with your future financial security. There are a number of ways to invest the death benefit you receive, and a financial representative may be able to help you determine what's best for you.
Taxes on Death Benefits
Every death benefit has its own limitations, such as taxes and creditor protection. Depending on where the money comes from, the restrictions of the death benefit may vary. For instance, death benefits from a life insurance policy are typically paid as a single tax-free lump sum. You will, however, need to report any interest earned on the proceeds.
Here are some of the most common types of death benefits and how they're taxed.
Stocks, Bonds & Real Estate
Stocks, bonds, real estate and many other types of investments typically receive a "step-up" in basis. A step-up in basis means that the investment receives the market value once the owner passes away. For example, if you paid $5 for a stock that increased in value to $100 over a 30-year period, you would normally have to pay capital gains tax on $95 (the difference between the purchase and the sale price). But if you held the stock until death, your beneficiaries would receive its current value at that time — $100 in this example — and would not be taxed on the gain that occurred while you were alive. If your beneficiaries were to sell the stock, they would likely be taxed based on the gain or loss on the $100 value.
Retirement Accounts
The type of retirement account and who you're inheriting it from will determine its tax treatment. For instance, if you inherited an IRA from a spouse, you could roll the funds into an existing IRA and be subject to the normal IRA tax rules. This includes paying income tax on any distributions and paying a 10% early withdrawal fee if you take distributions before age 59 1/2. This is just one example, though, and due to the complexities around the tax treatment of inherited retirement accounts, you'll likely want to talk to a financial professional to better understand your options and tax obligations.
Annuities
Annuities are taxed differently from investments. In general, the interest earned, which is the difference between the initial amount deposited and the value at death, is taxable at the regular income tax rates and receives no preferential treatment.
The Bottom Line
When receiving a death benefit, there are a lot of options when it comes to how you could spend the money. Before you make a plan, keep in mind that different types of investments and retirement accounts follow different tax guidelines for death benefits. If you still have lingering questions, a financial representative or a tax advisor may be able to help you find answers.
