Are Death in Service Benefits Taxable?
The tax treatment of a death in service benefit depends on its structure. Learn how the payment source and beneficiary designation affect tax obligations.
A death in service benefit is a lump-sum payment from an employer to the beneficiaries of an employee who dies while employed. This benefit is part of an employee’s compensation package and is not purchased directly. The funds often come from a group life insurance policy financed by the employer or a company-sponsored pension plan. The amount is frequently calculated as a multiple of the employee’s annual salary, such as two, three, or four times their yearly earnings.
Income Tax on Death in Service Payments
The income tax treatment of a death in service payment depends on its source. If the benefit is paid from a group life insurance policy, the proceeds are generally received by the beneficiary free from federal income tax. The payout is not considered income to the recipient, providing a financial resource without an immediate tax burden.
A different set of rules applies when the payment originates from a pension or retirement account, such as a 401(k). The portion of the benefit that represents the employee’s own after-tax contributions is returned to the beneficiary tax-free. However, the amount from employer contributions and any investment earnings is taxable as ordinary income to the beneficiary when it is received.
For these taxable distributions from retirement plans, beneficiaries may have options to manage the tax impact. A surviving spouse can roll over the taxable portion of the death benefit into their own Individual Retirement Account (IRA), which defers income tax liability. Non-spouse beneficiaries may also have a rollover option into an “inherited IRA,” but these accounts are subject to a 10-year rule, requiring the beneficiary to withdraw the entire balance within 10 years of the original owner’s death.
The payment method also influences the tax outcome. If a beneficiary receives a lump-sum distribution, the entire taxable portion is included in their income for that year. Some plans offer an annuity option, which consists of a series of payments. Each annuity payment is composed of a taxable and a non-taxable part, spreading the tax liability over several years.
Estate and Inheritance Tax Implications
Whether a death in service benefit is included in the deceased’s estate for federal estate tax purposes hinges on control and ownership at the time of death. The federal government imposes an estate tax on the transfer of assets after death, but only for estates exceeding a high exemption amount of $13.99 million per individual. This exemption is scheduled to be reduced at the end of 2025, and the value of the death benefit can be a factor in the calculation for larger estates.
The primary way to keep death in service proceeds out of the taxable estate is the beneficiary designation. When an employee designates a specific person as the beneficiary, the payment is made directly from the plan’s trust to that individual. This direct transfer bypasses the deceased’s estate, meaning the benefit’s value is not included in the gross estate calculation and is not subject to estate tax.
This outcome can change if the beneficiary designation is not handled properly. If the employee fails to name a beneficiary or names their own estate as the beneficiary, the proceeds will be paid into the estate. The funds then become part of the decedent’s gross estate and are subject to creditors’ claims and potentially federal estate tax if the total estate value surpasses the exemption. The proceeds are then distributed according to the deceased’s will or state intestacy laws.
To provide greater control, some individuals may have the death benefit paid to a trust. An Irrevocable Life Insurance Trust (ILIT) is a common tool for this purpose. By naming the ILIT as the beneficiary, the proceeds are kept outside of the estate, avoiding estate tax. The trust document then governs how the funds are managed and distributed, which is useful for managing assets for minor children or other complex family situations.
Tax Reporting Requirements for Beneficiaries and Estates
When a death benefit is paid from a pension, profit-sharing plan, or other retirement account, the plan administrator is required to issue Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. This form is sent to the beneficiary and the IRS.
Form 1099-R provides information about the distribution. It details the gross amount of the payment and identifies the taxable amount in Box 2a. The beneficiary uses this information to accurately report the taxable income on their federal income tax return.
If the death benefit is determined to be part of the deceased’s estate, the reporting requirements shift to the estate’s executor. The executor must file Form 706, United States Estate Tax Return, if the total value of the gross estate exceeds the federal estate tax exemption amount. The value of the death in service benefit would be included on this return as one of the estate’s assets.
For benefits paid from a pure life insurance policy that are not taxable income, a beneficiary does not receive a Form 1099-R and does not have an income tax reporting requirement for the proceeds.