If you just received a death benefit settlement from a life insurance company, you might be a little confused about taxes being taken out of it, or withheld. There is one very specific reason that an insurer would do this: if you are subject to special mandatory withholding by the IRS for unpaid or underpaid taxes for previous years. Otherwise, an insurance company won't withhold taxes from your death benefit.
Process
A life insurance company may be required to withhold money from a settlement it pays out to you if you owe back taxes or own a business and have underpaid your taxes. While life insurance benefits are generally tax-free, these extreme measures may be the only way for the IRS to collect on tax payments. The insurer may also be forced to give part of your money to the IRS if the IRS issued a federal tax lien and has started levy procedures for money that you owe. Generally, this would happen if you've been paid a death benefit claim, but have left the money with the insurance company and the IRS has issued a tax lien and levy on the death benefit held with the insurance company.
Significance
Life insurance is generally exempt from taxation, unless it is part of a qualified retirement plan, like a 412i retirement plan. In the case of a 412i plan, taxes are deducted from payments you receive from your employer since the plan is considered income to you. However, under normal circumstances, no taxes are withheld from a life insurance policy benefit payment.
Disadvantage
If you do have taxes withheld, there is normally not anything you can do about it. You'll have to contact the IRS to verify how much in back taxes you owe or whether a tax lien was placed on the policy, and get a copy of all IRS notices if you've lost the ones that were sent to you. In the end, you'll still have to pay your taxes and you'll lose whatever benefit was paid to the IRS for taxes.
Consideration
Even if you are subject to backup withholding, you might be able to recover some of the money if you are a business owner. Owning a business allows you to write off certain business expenses. Write off enough expenses, and your gross income is lowered. The lower your income, the lower your tax liability. In other words, if you write off enough in business expenses, you might get a refund for the amount -- or at least part of the amount -- that was withheld from you when the insurer paid the death benefit out to you.
