3974 / When an employee dies before retirement, how is the employee's beneficiary taxed on a single sum cash payment of the death benefit payable under the employee's qualified plan?

If a death benefit is payable from the proceeds of a life insurance policy, the difference between the cash surrender value and the face amount is treated as death proceeds of life insurance, and is excluded from income under IRC Section 101(a), but only if the insurance cost under Table 2001, the insurer’s qualifying term rate, (or previously under P.S. 58 ( Q 3948)) has been paid with nondeductible employee contributions or has been taxable to the employee.¹ The balance of the proceeds, representing the cash surrender value, is treated as a distribution from the plan.²

The following amounts may be subtracted from the cash surrender value and also excluded from gross income:

(1)  the sum of the annual term costs of life insurance protection previously taxed to the
employee ( Q 3952), but if the deceased was a self-employed owner-employee, the deceased’s beneficiary cannot subtract these costs even though they were not deductible by the owner-employee;

(2)  if the plan is contributory, the employee’s nondeductible contributions toward the cost of the insurance;

(3)  the amount of any loans included in the employee’s income as taxable distributions ( Q 3953); and

(4)  any employer contributions other than excess deferrals ( Q 3760) that have been taxed to an employee, including contributions in pre-1984 years on behalf of a more-than-5-percent shareholder-employee in an S corporation in excess of excludable amounts.

The balance, if any, of the cash surrender value is taxable according to the rules applicable to lump sum distributions ( Q 3971).

If an employer has purchased an existing policy from an employee for contribution to the trust, or if an employee has contributed it directly to the trust, the transfer for value rule
( Q 279) does not apply so long as neither the employer nor the trustee has the right to change the beneficiary. The IRS determined that there was no significant change in the beneficial ownership of the policy.³

Similarly, if a trustee of one plan purchases a life insurance policy from the trustee of another plan, there is no transfer for value where the beneficiary is entitled to designate the beneficiary both before and after the transfer because there has been no change in beneficial
ownership.⁴

If a contract is a retirement income contract, and the cash surrender value before death equals or exceeds the face amount, no portion of the proceeds is excludable as death proceeds of life insurance.⁵ The annual term costs of life insurance protection previously taxed to the employee would be excludable, except by the beneficiary of an owner-employee.

If the contract was distributed to the employee before his or her death, the IRS has previously considered the proceeds entirely tax-exempt as life insurance proceeds, although the Tax Court has considered them taxable as proceeds payable under an annuity contract, because death occurs after the element of risk has disappeared.⁶

If a contract distributed before death is subject to the definition of life insurance in IRC Section 7702 or IRC Section 101(f), the treatment of the death benefit would be as discussed in Q 65.

If a death benefit is not from life insurance proceeds, the beneficiary may subtract and receive tax-free any nondeductible employee contributions, the amount of any loans included in income, and any employer contributions other than excess deferrals ( Q 3760) that have been taxed to the employee. The balance, if any, of the death benefit, other than amounts attributable to deductible employee contributions, is taxable according to the rules applicable to lump sum distributions ( Q 3971).

A distribution to an employee’s beneficiary on account of plan termination, rather than on account of death, may not be treated as a lump sum distribution or as payment of an employee death benefit.⁷

A beneficiary may be entitled to an income tax deduction for any estate tax attributable to the distribution ( Q 3993).⁸